Wednesday, January 27, 2016

Capturing Price Movements in a Volatile Market

2016 is off to a rocky start, yet amid this market turmoil there exist great investment opportunities in prepay and relative value strategies. We have found that events of significant spread widening present real opportunity as historically, reversion happens rapidly. In the case of structured rates products such as Agency pass-through securities, it may be only a matter of days or weeks for the distorted price relationships between securities to revert to their historical norm. The slightly longer-to-recover prepay-sensitive bond spreads often revert within a quarter. As such, we are of the opinion that because the due diligence and allocation process can be arduous, it would be difficult to time an allocation to attempt to capture a specific event. Rather, since the strategy is interest rate neutral and provides a strong yet stable carry profile, an ongoing investment would be better suited to take advantage of these temporal opportunities. The culmination of these sources of returns leads to a projected asymmetric return profile.

Prepayment arbitrage, Tradex Relative Value’s core strategy, can offer a uniquely asymmetric return profile in most market environments. Given our tactical use of leverage and cash management practices, outsized spread widening events can be treated as buying opportunities as other investors are squeezed for liquidity and sell into fear. As illustrated below, we have found that spread widening events are often transient precede longer periods of spread tightening. In such circumstances, leverage and excess cash can be used to purchase cheap cash flows. We have observed this reversion effect many times over, and have built in processes to take advantage of such circumstances. Please see the chart below:
 


Example 1

Another significant spread widening event occurred following the surprise Mortgage Insurance Premium (MIP) cut in January 2015. The Federal Housing Agency (FHA), which provides mortgage insurance on loans made by approved lenders, cut the MIPs by 50 bp, thus creating a refinancing incentive for borrowers and leading to increased prepayment expectations. Spreads widened as a result, presenting an attractive trading opportunity that was quickly exploited within weeks. Our strategy successfully capitalized on this event by buying undervalued bonds in February 2015 and delivering 2.11% (net) that month.
 

While transient spread movements present opportunities to capture spread tightening, the high cash carry component inherent in the strategy and active hedging insulate the portfolio’s assets from large losses in these times of volatility, contributing towards the natural asymmetry of the strategy. Furthermore, compounding carry over a period can drive significant returns.

Not unlike the prepayment component of our strategy, relative value trading can provide similar opportunities. However, given the nature of relative value trading and liquidity of TBA markets, opportunities are often more numerous, yet the window in which to catch outsized movements is often smaller.


Example 2

One such example is the MIP cut, which presented a profitable trading opportunity to short the Ginnie II vs Fannie 4.0 agency swap. This dislocation lasted no more than a few weeks, and it was available only to those already invested in the Fund. We have regularly observed similar relative value trading opportunities in coupon swaps since the MIP Cut.


Example 3

Another illustrative example of a relative value trading opportunity was the basis widening that occurred during the 2013 Taper Tantrum, when the Fed suggested it may taper its QE program. During the Tantrum, the basis sold off between 1 and 4 percentage points and presented an excellent buying opportunity. The tightening rebound following the tantrum was around 2 months.


Summary

The Tradex Relative Value Fund utilizes its multi-strategy approach to capitalize on events when spreads widen and then subsequently tighten. Our Core Carry Strategy seizes these opportunities to invest in undervalued bonds, and our RV Strategy exploits these dislocations through opportunistically trading Agency pass-throughs against one another and against other rates products. We anticipate spread movements will offer many attractive investment opportunities in 2016, especially given the uncertainty in Fed policy and the instability of the global economy. We look forward to taking advantage of these events on behalf of our investors.

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