FLASH UPDATE: TRV Weekly Commentary - Vol Forthcoming

TRV Weekly Commentary
Week Ending 28 Oct 2014

Comment:

As of week’s end, rates are 20 basis points lower month-over-month, although the route here was anything but gradual. The UST 10-year yield reached an intraday low of 1.87 on October 15th and has since retraced approximately 70 percent of the peak to trough distance. With the Fed officially ending its Treasury purchase program, we begin to see signs of market volatility.

In addition, future market volatility may be exacerbated by decreased dealer liquidity, particularly in spread and credit products. Much has been written on this topic as investors, financial columnists and regulators express concern regarding potential illiquidity in volatile markets. For now, this week’s lull in volatility has been beneficial for spread and credit products: premium TBAs outperformed their Treasury hedges by between 3 and 9 ticks while IOS indices tightened between 30 and 40 basis points of OAS. Despite the “risk on” mentality, we maintain a cautious view as potential headwinds may arise.

Given our viewpoints, we thought we would use this week’s commentary to examine the costs of hedging an IO as we might do in the portfolio. Going long a position in IOS FN-2003 5.5% carries at 1.5 ticks a month. Adding FN 4.5 TBA to hedge the mortgage rate and neutralize duration exposure adds 8 ticks. To offset additional curve risk we might use interest rate swaps and/or US Treasuries, costing 1 tick. And given our view on volatility, we might utilize straddles to hedge gamma and vega, consuming 2 ticks. The net result is 6.5 ticks of carry.[1]

The above illustration shows that hedging activities can have a material impact on strategies that include carry as a source of returns. Some risks may be worth hedging, while others may not be depending on your market views. Of course, the best hedge is to have no position on at all, but the opportunity cost is great.

Happy hedging,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

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[1]  Calculations and table produced using Credit Suisse’s Locus platform