Tremors: The Evolution of a Short High Yield Strategy

The current high yield (HY) bubble can be thought of as an impending earthquake that is severe in magnitude and warning local inhabitants with foreboding tremors. We have been discussing the state of the HY market with investors for approximately two years now, shooting up flares and ringing alarms, like these communications in December 2013 and March 2014 (before and when our short strategy launched). The basic investment thesis has been that there are hundreds of companies that have had near unfettered access to capital markets due to unprecedented easy-money policies. Many of these companies did not merit this access, but nevertheless it was still cheap and easy for them to find refinancing or to issue new debt. These companies probably knew that at some point capital markets would become much harder and more expensive to access. The tremors are now much closer to each other and carry much more force, as we wind down a year that will result in the first annual HY loss since 2008. The “worst-of-breed” HY companies that we target are becoming easier to find, because there are so many of them. In this blog, we will review the evolution of a short high yield bond strategy in recent years.

City-life is bustling – 2009 to 2012: The Financial Crisis is over and companies that barely made it out of 2008 have licked their wounds. Helicopter Ben is QE’ing like crazy and capital markets are open for business. High yield companies have access and can raise large amounts of low-cost debt.  What do they do with it?  They extend their Ponzi-schemes by refinancing prior debt, by paying out dividends, by initiating expensive share buy-back plans and by making ill-advised acquisitions and LBOs.  In CCC’s, less than 10% of new bond issuance is used for corporate purposes, CAPEX or project finance.

Seismic activity deep underground – 2012 to 2014:  CCC’s that hung on in 2008 and levered up afterwards are seeing their businesses grind slower, with huge amounts of new competition, negative revenue trends, volatile EBITDA, declining and negative free cash flow and rapidly increasing levels of leverage.  Refinancing activity reaches fever pitch levels in 2014, accounting for 33% of all CCC new issuance activity by purpose.  The companies need breathing room and they need it fast. Yield-to-worst in the JPM US HY Index hits 5% as the Fed has indirectly forced investors into taking undue, credit-agnostic risk. Some HY companies secretly hope that they find a seat before the music stops. Seismic activity is starting to be registered, some small tremors are felt and some early adopters reduce exposures and start to prepare for the coming quake. 

A tectonic shift occurs – 2014 to 2015:  Macro headwinds persist and are being recognized and pointed out by many well-known market participants.  The inevitability of the cyclical nature of markets looms large – equity markets are tired and overextended, commodity markets are shaky and need EM growth to sustain, high yield markets are frothy. Famous market mavens are warning the masses. An interest rate hike is imminent and the Fed’s level of conviction is not confidence-inspiring. Over the last 43 years, on average, 56% of CCC issuance defaults within 7 years of issuance. The time is up. As flows turn negative, volumes recede, new issue activity slows, liquidity dries up and performance turns negative, can this time really be different?  As Mark Twain famously said, “History does not repeat itself, but it rhymes”.

Evacuation plans are put into effect – 2015 to TBD:  The tremors are no longer subtle and the fault lines are apparent. The collapse in oil prices has global impact, effecting commodity pricing across the spectrum, threatening employment gains, failing to positively incentivize the consumer to spend more and raising geopolitical tensions.  Bankers, who have plenty of choices for raising debt, recognize that capital markets are no longer quite as accommodative and choose safer borrowers to bring to market. Risk reassessment occurs overnight, repricing certain sectors such as telecom, cable and chemicals (ie. Sprint, Cablevision/Altice and Olin/Dow Chemical, respectively).The constant push and pull between bulls and bears is starting to shift to the bear side and liquidity is tested. 

Destruction followed by rebuilding – TBD:  The inevitable earthquake occurs swiftly, and companies will be torn down. Default rates have spiked and distressed players start looking for reclamation projects. This is a great time to be a long distressed buyer, but before that becomes a viable option, there will be lots of pain taken.

There is still time to get short of high yield bonds at asymmetric price levels. But, once the tipping point is crossed, market dynamics shift quickly and these bonds can no longer be borrowed. We have already established shorts near par in preparation for the earthquake in HY. This strategy is clearly an opportunistic one, and now is the time to protect a portion of your portfolio. Good luck out there.  #shortHY

Richard Travia,

Partner, Director of Research

The Tradex Relative Value Blog Series

Our latest research series considers relative value fixed income investment strategies that are liquid, market neutral and consistently produce alpha. We believe investors’ chief concerns include a changing U.S. interest rate policy, mitigating risks away from credit exposure, and maintaining liquid positions given the potential for increased volatility. In light of the current market environment as well as managerial constraints and goals, we outline a multi-strategy approach that touches on the above-mentioned environment and concerns.

Sources of Alpha in a Multi-Strategy Fixed-Income Portfolio

Overview

Given the recent increase in volatility and uncertainty in the global economic outlook, the rising tide that lifted all ships has given way to tumultuous waves that will pose problems for those who have been simply going with the tide. Alpha, the most frequently used metric for quantifying risk-adjusted returns, is measured as the difference between the unleveraged portfolio return and passive market exposure. Alpha is a relative metric with roots stemming from modern portfolio theory for traditional investments. During the strong bull market lasting from 2009 to 2014, beta exposure was often misclassified as alpha in fixed income strategies. An active, market-neutral approach that combines both strategic and tactical positioning is well-suited for generating alpha through exploiting market inefficiencies, while remaining insulated from the ebbs and flows of the market. However, market-neutral strategies can be thought of as a source of pure alpha since return is provided without benchmark exposure. Alpha can be enhanced through targeted, tactical exposure when market dislocations have created asymmetric return profiles with positive skew. Capitalizing on these dislocations provides tactical alpha through return enhancement and diversification. The following discussion focuses on the drivers of alpha within the context of a multi-strategy fixed-income portfolio.

Prepayment arbitrage of Agency structured bonds, as a fixed income arbitrage strategy, offers a variety of ways to capture alpha in structured products while hedging out exposure to interest rates (beta). Proprietary models aid US Government Agency investors in identifying opportunities when a security is cheap, relative to its intrinsic value. This is accomplished by establishing a more accurate view on prepayments and the resultant cash flows than what is priced into the market. Given the varying degrees of sophistication across the heterogeneous mix of fixed-income investors with differing objectives and constraints, those with superior models are presented with lasting opportunities to capture prepayment arbitrage. Purchasing cash flows that are overly discounted in the market, and intrinsically undervalued, generates a stream of incremental yield (hedge-adjusted carry) that serves as a persistent stream of alpha.

Relative value trading strategies in Agency pass-throughs can provide a pure alpha stream while investing in liquid securities. These securities, which are the second-most liquid fixed income instruments after US Treasuries, can be used for statistical arbitrage and mean reversion strategies that identify and profit from statistically significant deviations from normal market relationships. With the many constituents of the universe of Agency bonds, there are unremitting moments of detachment that can be capitalized upon in tactical, duration-neutral trades. These include the Agency basis (versus Treasuries or swaps), or pair trades in Agency coupon swaps, term swaps and inter-agency swaps. The return profile in these moments of dislocation is asymmetric and stop loss mechanisms further enhance the distribution to create a program with high-conviction, short-term trades that last from days to weeks.

Investing opportunistically in Non-Agency structured credit allows for a source of alpha, through the disproportionate upside offered at moments of technical dislocations that result in the mispricing of securities. Opportunistic purchases of securities are available to managers who are equipped and poised to act as a liquidity provider to investors seeking to sell at inopportune times (e.g. late in the trading day or low-volume days near a holiday or event). The gap between the purchase price and fair value is a liquidity premium that adds to alpha generation. There are also technical factors such as large liquidations or bursts of origination that can cause certain sectors to become displaced by forces that ultimately abate. Reduced correlations and incremental alpha are the end result.

Multi-strategy fixed-income portfolios are well-equipped to generate alpha in times of increased volatility. By implementing a duration-neutral combination of prepayment arbitrage, relative value trading and opportunistic credit, Tradex aims to provide superior risk-adjusted returns over a full range of market environments. 

Prepayment Arbitrage - Poised to Benefit in All Rate Paths

While many strategies are buckling under elevated macro volatility, flailing growth in emerging markets, freefalling commodity prices, and concerns over economic stability in Europe, there are specific features of prepayment arbitrage that make it an attractive strategy.

Prepayment sensitive securities are unique in that what drives fundamental performance is the behavior of individual homeowners. Every month, each homeowner faces the choice as to whether to continue to pay, to refinance, or default on their loan. This choice will be greatly influenced by such personal factors as household income, localized home prices, loan balance, and credit score, among others. These behaviors inevitably drive security cash flows, and thus performance of prepayment-sensitive securities.

While prepayment models have been developed to predict these behaviors, homeowners do not always act to maximize economic utility and so there are sources of model error. This is especially true for models that attempt to predict prepayments for large sectors of the market. Finely-tuned prepayment models are better equipped to project future cash flow and determine the relative rich or cheapness of a security. A manager that focuses on prepayment arbitrage must fully understand borrower behavior, market technical factors, and model projections.

A prepayment arbitrage strategy focuses on the market-implied behavior relative to the “delivered” behavior.
To accomplish this, a manager must actively manage the portfolio with respect to prepayments to understand the sources of risk in prepayment-sensitive securities, and use liquid instruments to neutralize unwanted risks. The excess spread captured in a market-neutral prepayment arbitrage strategy can be thought of as pure alpha, as the returns generated typically exhibit minimal risk and a predictable source of carry. Another significant benefit of the prepayment arbitrage strategy is that the hedges are typically accretive to carry, which improves the already significant cash-on-cash yield.

Investments in US Government Agency prepay-sensitive bonds provide a reliable source of cheap carry with uncorrelated returns to traditional and alternative asset classes. These assets, along with their hedges, can provide investors with a predictable source of income while minimizing interest rate exposure.

Why Now?

The approach, which targets interest payments from home loans, is agnostic as to whether interest rates rise, fall or stay the same given its hedged, market-neutral nature. If rates stay low or rally further, it would likely correspond with an economic contraction, which means less credit is available for homeowners to refinance. Alternatively, if rates rise, we expect carry would increase due to lower prepayment levels. As homeowners lose their incentive to refinance, superior prepayment modeling would be in a position to pick the most attractive securities in an environment of slower prepayments.

There are opportunities to spot mispriced securities and to capitalize on the present volatility. Global events including disinflationary pressures abroad, and a domestic Fed poised to move away from its Zero Interest Rate Policy, makes this an opportune time to exploit relative mispricing in prepayment-sensitive securities. Surveying the landscape of fixed-income alternatives, investors have extended duration or have taken on undue credit risk in this low interest rate environment to achieve returns. As other markets begin to appear close to fully priced, prepayment arbitrage strategies will likely exhibit less volatility while producing a stable source of return. The in-depth modelling of homeowner behavior that informs prepayment arbitrage strategies enables them to outperform and capitalize on uncertainty.

The Value of a Liquid Market-Neutral Fixed-Income Strategy

Since 2008, investors in hedge funds have demanded better liquidity terms and now, more than ever, avoiding illiquidity is a critical concern. With liquidity risk mounting due to a confluence of factors, it is paramount for managers to focus on strategies that can support shorter-term cash needs while providing a stable and attractive risk-adjusted return. An alternative fixed-income strategy that includes Agency relative value can achieve these goals through the tactical use of basis trades, dollar rolls, coupon swaps, term swaps and inter-agency swaps. We discuss the liquidity profile of these securities that form the basis of our Agency relative value trading strategy.

Strong Liquidity in the Agency Pass-Through Market

Agency pass-throughs are one of the most liquid fixed-income instruments after U.S. Treasuries. Commonly referred to as “TBA” (To Be Announced) securities, these securities trade as a forward market for Agency bonds, which are securities that are backed by the U.S. Government’s credit guarantee through Fannie Mae, Freddie Mac or Ginnie Mae. TBAs account for more than 90% of Agency pass-through trading, and there are scores of dealers active in the market. Issuance standards at both the loan and security levels give Agency pass-throughs a high degree of homogeneity, which helps to make the otherwise heterogeneous underlying loans extremely liquid. The average notional trading volume for TBAs is 165 billion USD per day, with bid-ask spreads ranging from 1/32 of a percentage in normal periods to 3/32 in extreme environments. The depth of the TBA market and low bid ask demonstrate just how liquid this market is. It is worth noting this market remained robust during the financial crisis, while structured credit and high yield corporate credit issuance declined to untenable levels. The outstanding stock of Agency bonds during this period of acute duress actually increased from 3.99 trillion USD in 2007 to 5.27 trillion USD at the end of 2009. Agency pass-throughs clearly stand firm as one of the strongest avenues of liquidity across all fixed-income securities.

Relative Value Trading in the Agency Pass-Through Market

TBAs are not only liquid, but also offer frequent alpha opportunities when traded tactically. Relative value (RV) trading strategies in Agency pass-throughs often register significant dislocations which can be capitalized on via statistical arbitrage and mean reversion trading. In the case of a basis trade, TBAs can be hedged using U.S. Treasuries, creating a duration-neutral position with an attractive risk-return profile. We give a few examples of RV strategies that may be available in this space. Agency basis trades typically exploit moments of detachment in the pricing of Agency securities relative to U.S. Treasuries or Interest Rate Swaps by either going long or short the basis. Trades in the dollar roll market profit from moves in the “drop”, which is the difference in price of TBA securities between settlement months. Coupon swaps can be used to exploit mispricing between Agency securities with different coupons, as technical factors in the market and origination channels can distort relationships across the coupon stack. Term swaps target valuation differentials between securities issued by the same Agency with different maturity terms. Similarly, inter-agency swaps exploit dislocations in the prices of bonds of the same coupon and term, but issued by different Agencies. There are a variety of relative value strategies that can be utilized in the TBA market, and these tactical trades can be effective largely due to the ultra-liquid nature of this market.

Potential threats facing investors include credit and “liquidity” risk. A fixed-income arbitrage strategy that includes Agency relative value is well positioned to meet rising challenges that investors face from increased liquidity concerns while providing alpha opportunities and a low correlation to traditional assets. In the case of the Tradex Relative Value Fund, we believe this ultra-liquid component of our multi-strategy approach will keep our overall liquidity very advantageous in the current environment.

What's Next in Credit

Following the 2008-2009 financial crisis, credit-sensitive securities experienced unprecedented spread widening as investors lost confidence not only in homeowners’ ability to repay mortgages, but in housing finance altogether. Being short of credit-sensitive securities during this period and subsequently purchasing over-penalized securities provided exemplary opportunities to generate outsized returns. Having navigated the Big Short and the Big Recovery, the Tradex team has adopted an opportunistic sub-strategy that is capable of taking advantage of such outsized market moves. While the Big Recovery has all but ran its course, there are a few sectors worth watching in the current credit cycle.

GSE Credit Risk Transfer (CRT) 

Government-sponsored enterprises (GSEs), like Fannie Mae, Ginnie Mae and Freddie Mac, issue credit risk transfer (CRT) bonds to transfer a portion of credit risk on mortgages they guarantee to private investors. Such a transfer has the added benefit of diversifying credit risk among several investors, as opposed to concentrating it in the hands of GSEs. Spread widening and risk-off sentiment has pushed CRT spreads wider and the credit curve steeper.  At the same time, the housing market continues to recover and the current low interest rate environment (i.e. low refinancing incentive for borrowers) remains supportive of fundamentals.  While there is value across the CRT space as a whole, we see the best risk/reward in the last cash flow (LCF) tranches. These classes have benefitted from strong housing fundamentals, resulting in homeowner balance sheet deleveraging due to strong prepayments and low defaults. With spreads 450 to 500 over swaps and spread durations of 7 to 8 years, we see this sector as having the potential to return 7 to 10 percent over the next year with strong carry and modest roll-down/spread tightening. Issuance of CRT remains strong and by all accounts, the market is here to stay.

Non-QM 

The qualified mortgage (QM) rules opened the door for private investors to originate non-qualified mortgages, and these loans are now becoming a factor in the RMBS market. Lenders are currently seeking access to the securitization market, after reshaping the credit box to provide financing to creditworthy borrowers who were left out by the restrictive QM regulations, such as a debt-to-income ratio of 43% or less. In September, Loan Star issued a $72 million transaction that stands as the first transaction secured primarily by non-QM loans. The M1 tranche of that transaction has 6% of credit support and bears a 6.8% coupon. We expect more deals like this to price, offering potentially attractive investments in the credit space that can be exploited opportunistically.

CMBS 

While there are pockets of opportunity in the legacy CMBS market, most securities are priced to optimistic scenarios. Legacy CMBS bonds are also running off quickly as we navigate the 2015 – 2017 maturity wave.  Going forward, CMBS 2.0/3.0 will likely provide tactical and strategic opportunities to investors who are able to discern between the various loan pools. In-depth analysis is key to security selection for finding misunderstood pools that may not be priced to optimistic scenarios. CMBX tranches also provide investors with a liquid means of expressing positive or negative views in this sector. At present, the BBB tranches look attractive after suffering during the global rout in August and September. The 2.0 BBBs trade at spreads in the mid-300s over swaps with average lives of 6 to 7 years.  New issue 3.0 BBBs carry more spread duration with WALs of 9 to 10 years, but trade with spreads closer to 500bp over swaps.  At current levels, these securities yield 5 to 7% and offer good carry with fixed rate coupons. As we pass through the 2015-2017 maturity wave, loan demand and issuance will begin to taper, resulting in technicals that are supportive to spreads. The present situation in CMBS may be prime for investment managers with cash holdings and deep knowledge of the space to opportunistically navigate the coming quarters.  

Overall, the potential opportunities in mortgage credit make this investment space interesting for early adopters equipped with the expertise and cash on hand to take advantage of what’s next.

Summary

As fixed-income investors consider liquidity risk and changes in the Fed’s zero interest rate policy, the need for investment strategies that are liquid and market-neutral becomes clear. This series examines sources of alpha and interest-rate-neutral trading strategies within the context of a multi-strategy fixed-income portfolio. The Tradex Relative Value Fund manages such a strategy, where it seeks to capitalize on opportunities in prepayment arbitrage, relative value pass-through trading, and opportunistic structured credit. We believe our multi-strategy approach will provide investors with alpha generation as well as liquid positions that are market-neutral and can deliver strong risk-adjusted returns.

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global