TRV Weekly Commentary
Week Ending 28 Oct 2014
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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