Wednesday, May 11, 2016

IOs: A High Yielding Alternative

We outline key features of the Tradex Relative Value Fund’s market neutral portfolio of Agency backed Interest Only (IO) and Inverse Interest Only (IIO) securities. Such a hedged portfolio may deliver attractive, stable returns, which can be enhanced with conservative use of leverage. A key component of this strategy’s stability is the high level of reliable carry it earns, which can be in excess of 50bp per month on an unlevered basis. Interest rate exposure can be hedged to protect this income stream. Hedging dynamically can generate interesting relative value trading opportunities as a potential source of alpha. Furthermore, a large cash position is maintained to opportunistically capitalize on market dislocations as they arise. 

The Tradex Relative Value Fund’s (TRV) annualized net performance was 3.63% with a Sharpe ratio of 1.56 since inception (the period January 2015 through February 2016). To-date we have used no leverage, but we expect to tactically utilize leverage in the future.

In the table below, we compare these results with the performance of high yield bonds, and fixed income arbitrage hedge fund strategies. Fixed income investors targeting high single digit returns may find using conservative levels of leverage on a hedged portfolio of Agency mortgage-backed securities is an attractive investment opportunity when compared to these alternatives. Hedging interest rate risk is especially beneficial to investors given the uncertainty surrounding Fed policy. 
Furthermore, Agency mortgage-backed securities are implicitly guaranteed by the US Government, which makes them unique among fixed income instruments in that they do not have credit exposure and yet they offer higher yields than Treasuries. The combination of these factors creates a generous and dependable income stream for investors in this strategy.

Annualized Return (unlevered)
Standard Deviation
Sharpe Ratio*
ƚ TRV net returns
HYG: Adjusted returns for iShares iBoxx $ High Yield Corporate Bd
HF FI Arb: DJCS Hedge Fund Index Fixed Income Arbitrage
* Risk-free rate of 1 Month LIBOR at 0.31%

Tuesday, March 8, 2016

Tradex Global Short-Biased High Yield Fund Ranked #3 Fixed Income - HY Fund in January by BarclayHedge

The Tradex Global Short-Biased High Yield Fund was ranked the #3 "Fixed Income - High Yield" Fund by BarclayHedge for January. Please see the below award:

This fund was ranked based on the data in BarclayHedge's Database of hedge fund managers

Tuesday, March 1, 2016

Default-Risk-Adjusted Returns

Fixed income investors interested in achieving enhanced risk-adjusted returns must carefully consider risks, such as prepayment and default, that affect realized yields associated with different types of bonds. In this write-up, we compare the risk-return profiles of Agency and non-Agency securities as well as corporate debt obligations. We find that Agency Interest Only (IO) securities have historically provided investors with higher carry at reduced levels of risk relative to other fixed income products. Non-Agency IOs may also offer good investment opportunities, but this depends on market spreads and the quality of prevailing underwriting standards. In recent years, these standards have greatly improved from those used during the Financial Crisis. When compared to Agency and non-Agency securities, corporate debt obligations offer suboptimal risk-adjusted returns. Corporate bonds also require investors to perform laborious underwriting to understand fully their vulnerability to default. Our analysis indicates that Agency IOs offer a unique risk-return profile for fixed income investors by providing the security of US Government backing at higher yields than US Treasuries. 

Agency Securities

Defaults in Agency IOs are termed involuntary prepayments. These occur when a borrower stops making payments and the Agency (i.e. Fannie Mae, Freddie Mac, Ginnie Mae) must step in to pay back (i.e. prepay) the balance of the principal of the government guaranteed loan. Fannie and Freddie Mac report the default rates on loans underlying selected Agency securities. These involuntary prepayments are measured by the Constant Default Rate (CDR), which is the annualized percentage of principal involuntarily paid off via default. We find that the average annualized CDR from January 2000 through June 2015 (the most recent data) was 0.84% for Fannie Mae and 0.82% for Freddie Mac, as shown in Chart 1. During the height of the Financial Crisis, Fannie and Freddie bonds had annualized CDRs of 3.34% and 3.11%.

Chart 1: Agency CDRs

Non-Agency Securities

Non-Agency deals are issued by banks. They are often constructed with several different tranches, each with its own distinct level of exposure to credit risk. Loan-level detail analysis is often necessary to understand fully a particular security’s exposure to default risk. As observed in Chart 2, default rates vary widely depending on a security’s collateral quality as Prime, Alt A, or Subprime. From 2011 through 2015, average CDRs were 2.89% for Prime, 5.90% for Alt A, and 7.58% for Subprime. 

Chart 2: Non-Agency CDRs

We believe Non-Agency securities may offer attractive risk-adjusted returns, depending on where we are in the credit cycle and the quality of underwriting practices. However, since these conditions vary, we maintain an opportunistic approach to Non-Agency credit. Recently, we have consciously avoided investing in Non-Agency securities as yields are relatively tight, though we are always on the lookout for when the timing may be right for credit exposure. 

Corporate Bonds

When compared to Agency and Non-Agency securities, corporate bonds do not have attractive default-risk-adjusted returns. This is in part due to the difficulty involved in understanding credit exposure in corporate debt, which requires investors to perform laborious underwriting. Moreover, this time-consuming analysis still does not insulate investors from the idiosyncratic risk inherent in bonds issued by a single company. Agency and non-Agency securities benefit from diversification, since each bond is backed by hundreds, if not thousands, of individual loans. In addition, it is important to not be fooled by the purportedly low number of “Investment Grade” (AAA through BBB-) defaults, because these numbers do not include the so-called “fallen angels”, which are companies that were downgraded prior to going bankrupt.

Yield Comparison

Having examined default rates, we now turn to yields in our discussion of risk-adjusted returns across fixed income assets. The yields typically found in Agency IO securities range from 5 to 6%, while non-Agency RMBS usually yields around 5-7% , and High Yield corporate bonds (unadjusted for default) may yield 7-10%. It is important to note that the yields for High Yield bonds assume all cash flows are realized with no defaults, which explains why they are often greater than Agency IO yields. Also, non-Agency securities may typically have higher yields than Agency IOs at the cost of illiquidity, credit exposure, and longer periods until the return of capital. In light of this, the 5-6% yields one can expect from Agency IO strategies represent an outstanding risk-reward profile. 

Another factor in assessing the attractiveness of a fixed income investment is the capital requirement. Corporate bonds require investors to put up a relatively large amount of capital for a semi-annual coupon and a principal amount that is not returned until the bond matures, usually in 10 years or more. In the case of Agency IO securities, investors purchase a stream of monthly interest payments that tend to be front-loaded. As such, capital is returned at a much faster rate, often offering a more attractive yield over a shorter timeframe. Thus, for fixed income investors, Agency IO securities can offer yet another advantage over corporate debt and US Treasuries.

We find there are many sound reasons for investors to have exposure to Agency and non-Agency securities. The Tradex Relative Value Fund primarily invests in Agency securities in a market-neutral portfolio that seeks attractive absolute returns. As previously mentioned, we may, at times, invest opportunistically in non-Agency securities, if the conditions are right for us take on credit exposure. We aim to hedge interest rate risk by maintaining a near-zero duration book along with superior loss-adjusted returns. This market-neutral strategy has delivered enhanced risk-adjusted returns for our investors, offering competitive yields and generous carry with limited downside.

We recommended readers interested in learning more about the Tradex Relative Value Fund’s strategy to contact  

Monday, February 8, 2016

Tradex Global Short-Biased High Yield Fund Ranked #7 Fixed Income - HY Fund in 2015 by BarclayHedge

The Tradex Global Short-Biased High Yield Fund was ranked the #7 "Fixed Income - High Yield" Fund by BarclayHedge for 2015. Please see the below award:

This fund was ranked based on the data in BarclayHedge's Database of hedge fund managers

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.


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.