FLASH UPDATE: Mortgages Outperform Treasuries on FOMC Statement

Mortgages Outperform Treasuries on FOMC Statement

The Federal Open Market Committee announced last Wednesday that it will use “a wide range of information” to assess how long it will maintain a 0 – 25 bps target range for the Federal Funds Rate.  The Fed has effectively reduced the dependence on its 6.5% unemployment target for policy considerations, as the unemployment rate is nearing 6.5%.  The announcement came as a surprise, sending mortgage and Treasury yields higher.

The Treasury curve experienced a ‘Bear flattener’, as short rates increased more than long rates.  Yields on the 5 Year Note increased 16 bps to 1.71% while yields on the 10 year Note increased 10 bps to 2.77%.  Market participants are pricing in a rate hike sooner than was previously anticipated following the Fed’s statement last week.  Consequentially, investors sold the front end of the curve.

Not surprisingly, mortgages performed very well against 5 year Treasury hedges.  Discount and current coupons performed very strongly as they increased more than 0.50% following the announcement.  Premiums, on the other hand, only increased 0.10% to 0.15% against their hedge counterparts.  Mortgage performance against 10 year Treasury hedges was poor, as only discounts outperformed their Treasury hedges.

There were no surprises with respect to the pace of Fed “Tapering” its asset purchases – as the market widely anticipated last week’s announcement of an additional $5 Bln of Treasury and $5 Bln of Agency MBS tapering.  Going forward, the Fed will purchase Treasury and Agency MBS Securities at a rate of $25 and $30 billion per month, respectively.

The Fed also released economic projections last week.  The Fed expects real GDP to expand between 2.8 and 3.0 percent in 2014, 3.0-3.2 percent in 2015, and 2.5 – 3.0 percent in 2016.  Moreover, the Fed expects the unemployment rate to range between 6.1 and 6.3 percent in 2014, 5.6 to 5.9 percent in 2015, and 5.2 to 5.6 in 2016.  These economic projections were meaningfully improved from December.

The lower panel of the graph below shows the strong performance of discount FNMA 3.0 MBS against their 5 year Treasury hedges beginning with the 2pm announcement last week.  They rallied about 0.50% and have continued their strong performance through the remainder of the week.

Relative value opportunities are abundant in this environment, creating strong profit potential in Agency MBS RV based strategies.  To further discuss, please contact Jeff Trongone at 203-863-1518 or jeff@thetradexgroup.com. 

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: Spread Risk, Duration Risk, Price Risk and Credit Default Risk

Spread Risk, Duration Risk, Price Risk and Credit Default Risk

Are those enough risks for you?  As we continue to try to better understand the inter-connectivity of the macro and micro economy, similar themes persist.  Bubbles are inflating in junk bond issuance, credit quality and yields.  As the risks in the high yield market continue to inflate and metastasize, potential returns in the space have become laughable.  According to John Phelan, a fellow at the Cobden Centre, “…the Federal Reserve has become an enabler of the financial havoc it was designed to prevent.”  This, of course, has been well-documented and discussed by Tradex over the years.  The problem with euphoric markets (ie. the current fully heated high yield credit market) is that no one wants to exit until they are sure everyone is leaving.  Naturally, we know in hindsight, that it is typically too late to sneak out the tiny door at that point. 

This morning a Bloomberg article was printed citing well-known hedge fund operator Marathon Asset Management as saying, “We hate high yield…” and …”It’s trading at dangerous levels.”  Spreads between high yield bonds and investment grade have recently hit all-time record tights.  Concerns about duration exposure in bond portfolios has been downplayed for the time being, but if interest rates rise – bond prices could fall significantly.  As a rule of thumb, a bond with a duration of 10 years would experience a price decline of 10% in the event that interest rates rise 1%.  The number of corporate defaults is well below average currently, and well-known high yield gurus and hedge fund operators are starting to ramp up their default expectations.  Historically, 45% of CCC-rated issues default cumulatively four years after issuance.  Danger lies ahead…

The forgetful survivors of the last credit bubble pledged that they’d be more careful, less greedy and less-short-term oriented.  We haven't forgotten the fear and pain that was enigmatic of most days in 2008.  When we look at the bottom tier of the high yield market, we recognize that leverage has risen again, stricter lending policies have not been heeded and balance sheets are fragile.  The sub-investment grade universe has seen record bond issuance, and unsustainable low default rates.  Someday rising bond markets will no longer be government policy, and QE will end.  At some point, corporate failure will be allowed again.  Someday, interest rates will be higher, bond prices will be lower and owning fixed income may be more attractive.  Yesterday, betwixt and between continued "Taper" talk, Fed Chairwoman Janet Yellen suggested that the first rate hike may come sooner than the market expected.  As we have playfully illustrated in the past, when the music stops, finding an empty seat is harder than it looks.  Today, we think being short high yield is the only way to be involved in (and a survivor of) the risky corporate credit market.

Richard Travia
Director of Research

FLASH UPDATE: So Long Fannie & Freddie!

Senate Bipartisan Proposal on Housing Reform Expected to Have Little to No Impact on the TBA Market and Relative Value Strategies

On Tuesday the Senate Banking Committee (Chairs Johnson & Crapo) announced a bipartisan agreement on broad principles for housing finance reform as it pertains to the wind down of Fannie Mae and Freddie Mac. They expect to have a working proposal in the next few days.  However, it is unclear whether the House will act this year on a similar bill even if the Senate does ratify such a proposal.  Furthermore, the Senate didn’t suggest how existing shareholders in the GSEs would be affected.  Nevertheless, the stock market response for GSE equity holders has been swift and dramatic, with share prices of both entities down almost 40% since the announcement.

Freddie Mac Equity

Fannie Mae Equity

The reaction in the debt markets for Agency MBS and the TBA market could not have been more different than that of the equity market.  Iin fact, it was essentially a non-event.  In particular, the “Mortgage Basis” – defined as the yield spread between MBS and Treasury securities – widened about +1 bp on Tuesday with most of that movement occurring prior to the announcement.

This is a welcome development for traders in the most liquid of mortgage strategies.  Market participants had been expecting that any housing policy reform would leave TBAs largely unaffected.  And indeed, Tuesday’s announcement confirmed that view.

This is not to say that the announcement was not noteworthy to participants in the housing markets, which includes just about everyone.  To summarize, the broad principles were:

1. Protect taxpayers for future housing downturns
2. Promote stable, liquid and efficient mortgage markets
3. Ensure affordable 30-year fixed rate, prepayable mortgages
4. Provide equal access to mortgage capital for all lenders, large and small
5. Facilitate availability of mortgage credit to all eligible borrowers

To meet these objectives, several details have been agreed upon that will form the basis of the Johnson-Crapo proposal:

1. Continue with the wind down of Fannie Mae and Freddie Mac
2. Promote a new system based on private capital absorbing the first 10% of losses on mortgage securities
3. Create the Federal Mortgage Insurance Corporation (“FMIC”), funded by 10bps of insurance premiums on every guaranteed mortgage to absorb losses in excess of 10%
4. Require strong underwriting standards

We continue to believe that the pending re-invention of the government-guaranteed mortgage market will present a myriad of opportunities in mortgage credit trading and in mortgage insurance companies.  However, Tuesday’s development also confirms that opportunities in the most liquid strategies within the mortgage market will be largely unaffected.

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: How will the HY story end?

Hindsight is a wonderful thing.  It is easy to go back, review past events and to poetically postulate on what could happen next.  The age of internet has given everyone the power to quickly and easily refresh their memories.  If that is the case, why are investors still reaching for yield in the lowest rated junk bonds when they know how the story will end?  We have seen this story play out before, and expect that it will again end badly. 

Michael Milken first started pitching junk bonds for the masses in the early 80’s.  Thirty years later, the Fed has replaced Milken as one of the biggest supporters of junk bonds thanks to 0% interest rates and easy money policies.  Investors have appeared incredibly complacent by owning this asset class without reservation; the same asset class that always gets hit hard when a whiff of increased defaults comes to the fore.  For now, money is still flowing into mutual funds and ETFs that invest in junk bonds.  We have seen the pace starting to slow over the last three weeks though, with $559 m of purchased high yield funds in the week ended February 26^th, which was proceeded by $804 m of inflows the week before and $1.45 b the week before that.

After a year of abundant liquidity and near record setting HY issuance, the HY default rate remained below historical averages and decreased from 2012 to 1.04% (the 8^th lowest rate since 1971).  According to Ed Altman, sixty-four companies with debt greater than $100 m filed for Chapter 11 bankruptcy protection in 2013, 7% less than in 2012.  The number of bankruptcies is less than the historical annual average of 75.  Altman, Marty Fridson and many other well-known prognosticators are starting to sound alarm bells, warning of an impending rise in the default rate and bankruptcies.  While some investors have ignored these warning signs, Tradex has been preparing.

We know, through the power of hindsight, that 45% of CCCs default or restructure four years after issuance.  After record issuance in 2012 and 2013 and an inevitable spike in the default rate, Tradex will be ready.  We will be short of the worst performing, highly levered, subordinated junk bonds that benefitted from indiscriminate, credit agnostic, yield-hungry buying.  Michael Milken’s run as “junk bond king” ended  abruptly with him spending two years in jail.  We don’t know exactly how the HY story will end this time around, but we are pretty sure it will end badly.  

Richard Travia

Director of Research