FLASH UPDATE: Anatomy of a Market-Neutral Mortgage Strategy

Market-neutral strategies profit from identifying and exploiting mispriced securities while eliminating the impact from market movements.  In this piece, we provide a straightforward overview of a market-neutral approach within a mortgage strategy. If markets were completely efficient, then a fully hedged portfolio would earn the risk-free return. It would be irrational for a manager to go through the process of strategy building and portfolio management when simply purchasing T-Bills would produce the same outcome. In reality, market inefficiencies do exist and the most skilled managers capitalize on them to generate a persistent stream of positive risk-adjusted returns by prudently taking calculated risks. In general, the goal of a fixed-income arbitrage strategy is to hedge out the unwanted (market) risks while generating returns through exploiting pricing inefficiencies (sector/security).  In a mortgage strategy, the most persistent source of return is hedge-adjusted carry - income earned net of hedging costs.  Other sources include statistical arbitrage and opportunistic purchases of fundamentally undervalued securities.

Interest Rate Risk

The primary driver of returns in a fixed-income security is its duration, or interest rate sensitivity.  This is the foremost source of market risk, and successful market-neutral strategies buffer the portfolio against it by implementing a hedging strategy to maintain a near-zero duration with minimal yield curve exposure. An optimal mix of hedges (cost and efficacy) are selected to offset the partial durations of the portfolio’s core investments.  Treasury and Euro Dollar futures and options are commonly used to hedge duration.

Spread Risk

Movements in spreads (risk premia) also affect the valuation of fixed income securities, and sensitivity to this risk factor is measured by spread duration. Risk premia can increase for a variety of reasons. Some of the main drivers include expectations of weakening market fundamentals, the ensuing effects of an increase in volatility, and intermittent technical factors causing a glut of supply.  Spread risk can be offset using a variety of hedging instruments.  Swaps and swaptions are effective hedges against interest rate volatility and broad market moves in risk premiums, while mortgage securities and the mortgage basis can be used to offset phenomenon that are more local to the mortgage market. Value-at-risk (VaR), an industry standard risk metric, can be used to measure spread risk using historical spread volatility for the types of securities held in a portfolio and to manage the exposure to be within an acceptable bound (e.g. 2%).  By managing this risk within a range, the strategy accomplishes two things: 1) the ability to generate hedge-adjusted carry is not impaired from over-hedging and 2) as deemed necessary, the resulting savings can be used for tail hedges to further protect against systemic risk.

Risk Adjusted Returns

Tradex delivers a market-neutral product in its multi-strategy mortgage portfolio with the aim of providing investors with an all-weather investment resource that generates persistent alpha through a return series that exhibits reduced volatility and low correlations to traditional and alternative investments. 

Please contact us if you would like to hear more about this topic or anything else regarding our strategy.

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

Remembering September 11th

To all of our friends and business partners,

Tradex wants to remember the victims and those affected by the September 11^th tragedy and have decided to donate a portion of our September fees to Tuesday’s Children, a charity that promotes long-term healing for those directly impacted by the tragic 9/11 event.  Tuesday’s Children provides programs such as career counseling, youth mentoring, mental health & wellness, widow support programs, life management skills, among others.  We encourage you to make a donation to this worthy cause for those in need.  Please click here to make a donation now:  http://www.tuesdayschildren.org/donate/#.VfHk5BHBwXA

Best regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: Versatility of CMBS

Summary

CMBX indices are widely referenced market instruments among structured credit investments.  Yet, we find that a large portion of investors are operating on partial information in regards to the various uses of CMBX and the potential benefit from active management.

Definition of CMBX

Each CMBX index is a basket of credit default swaps (CDS) on a static basket of CMBS and provides investors with a means of obtaining diversified exposure to specific rating categories within the reference pool. A majority of the 20 primary dealers make active markets in CMBX, making the indices liquid and accessible. The transparency of widely quoted markets and bid/ask spreads that are narrower than bonds in the cash market provide investors with an efficient and versatile tool for expressing varying views in CMBS. 

Mechanics of CMBX

CMBX contracts are structured to closely follow the cash flow of the underlying deals, according to Internal Swaps and Derivatives (ISDA) “pay-as-you-go” (PAUG). In this CDS format, the buyer and seller make two-way payments over the life of a contract.  The performance of the contracts is structured to provide investors with a means of expressing a positive or negative view on the basket of bonds in the basket of reference securities.

CMBX buyers “sell protection” by taking on risk associated with the CMBS portfolio and profit when the reference pool performs better than the implied performance at the time of purchase.  In essence, they are exhibiting a bullish view.

CMBX sellers “buy protection”, and pay an upfront fee and fixed premium to index buyers in exchange for payments to cover losses in the event of any writedowns or shortfalls.  They are either aiming to hedge or express a bearish view.

Source:  CMBX The Long and Short of It, CRE Finance Council 2014

Hedging

CMBX can be used to hedge a portfolio against credit exposure as well as systemic market movements.  Credit risk on a portfolio can be mitigated through taking a short position in a tranche with similar characteristics as the portfolio.  However, basis risk increases over time as the credit performance of the specific securities referenced by the CMBX and those held in the portfolio drive the respective outcomes.  To hedge market risk, newly issued series are an effective tool given their high correlation to market indices like the S&P 500.  The correlation is driven by ease of access and low capital commitment, allowing investors to quickly and efficiently express a risk-off view to protect against a systemic sell-off in credit markets.  The chart below illustrates the relationship between the S&P 500 and the A tranche of the CMBX.6 series (CMBX.6.A).  It demonstrates how tactical short positioning as sentiment shifts provides a means to cushion the downside.

During major market drawdowns, there are opportunities for hedging by shorting CMBX.

Directional

With the observed relationship between a benchmark index like the S&P 500 and certain CMBX indices, it is logical that there would also be opportunities to profit from directional moves in broad markets on major shifts in sentiment.  Investors can go long or short in CMBX accordingly to reflect their expectations for market performance.  As an example, taking a view based on a technical indicator like the RSI to gauge the potential for a directional move in the broader market, one can implement a CMBX strategy with the aim of profiting from near term shifts in sentiment.  Examples of such moments are annotated in the graph.  

In the rebound period following major market corrections, there are opportunities for directional long trades.

Relative Value

CMBX can also be traded using a relative value strategy, where opportunities arise from dislocations in the pricing of different tranches within a given series. As an example, we developed and tested the effectiveness of a multilinear regression model to predict CMBX.6.AA. We chose CMBX.6.A and CMBX.6.AAA as our explanatory variables.  As shown in the chart, relationships between highly correlated tranches can be modeled and used to signal relative value trades.  Statistically significant dislocations serve as potential opportunities.

Conclusion

CMBX is a multi-faceted tool that provides investors with efficient means for achieving a range of objectives. Those well versed with this product can utilize it in the active management of a portfolio to add incremental returns across a dimension of market environments. It is a useful tool for opportunistic investors to include in their alpha sources.

Please contact us if you would like to hear more about our view on this trade thesis or our other thematic ideas.

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

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

In July, the Tradex Global Short-Biased High Yield Fund was ranked for the 2nd month in a row by BarclayHedge, this time appearing as the #3 "Fixed Income - High Yield" Fund.  Please see the below award:

This fund was ranked based on the data in Barclay Hedge's hedge fund database