FLASH UPDATE: The Value of a Liquid Market-Neutral Fixed-Income Strategy

The Value of a Liquid Market-Neutral Fixed-Income Strategy

Since 2008, investors in hedge funds have demanded better liquidity terms and now, more than ever, avoiding illiquidity is a critical concern. With liquidity risk mounting due to a confluence of factors, it is paramount for managers to focus on strategies that can support shorter-term cash needs while providing a stable and attractive risk-adjusted return. An alternative fixed-income strategy that includes agency relative value can achieve these goals through the tactical use of basis trades, dollar rolls, coupon swaps, term swaps and inter-agency swaps. We discuss the liquidity profile of these securities that form the basis of our Agency relative value trading strategy.

Strong Liquidity in the Agency Pass-Through Market

Agency pass-throughs are one of the most liquid fixed-income instruments after U.S. Treasuries. Commonly referred to as “TBA” (To Be Announced) securities, these securities trade as a forward market for Agency MBS, which are securities that are backed by the U.S. Government’s credit guarantee through Fannie Mae, Freddie Mac or Ginnie Mae. TBAs account for more than 90% of Agency MBS trading, and there are scores of dealers active in the market. Issuance standards at both the loan and security levels give Agency pass-throughs a high degree of homogeneity, which helps to make the otherwise heterogeneous underlying loans extremely liquid. The average notional trading volume for TBAs is 165 billion USD per day, with bid-ask spreads ranging from 1/32 of a percentage in normal periods to 3/32 in extreme environments. The depth of the TBA market and low bid ask demonstrate just how liquid this market is. It is worth noting this market remained robust during the financial crisis, while structured credit and high yield corporate credit issuance declined to untenable levels. The outstanding stock of Agency MBS during this period of acute duress actually increased from 3.99 trillion USD in 2007 to 5.27 trillion USD at the end of 2009. Agency pass-throughs clearly stand firm as one of the strongest avenues of liquidity across all fixed-income securities.

Relative Value Trading in the Agency Pass-Through Market

TBAs are not only liquid, but also offer frequent alpha opportunities when traded tactically. Relative value (RV) trading strategies in Agency pass-throughs often register significant dislocations on which astute investors can capitalize via statistical arbitrage and mean reversion trading. In the case of a basis trade, TBAs can be hedged using U.S. Treasuries, creating a duration-neutral position with an attractive risk-return profile. We give a few examples of RV strategies that may be available to a skillful manager in this space. Agency mortgage basis trades typically exploit moments of detachment in the pricing of mortgage securities relative to U.S. Treasuries or Interest Rate Swaps by either going long or short the basis. Trades in the dollar roll market profit from moves in the “drop”, which is the difference in price of TBA securities between settlement months. Coupon swaps can be used to exploit mispricing between Agency securities with different coupons, as technical factors in the market and origination channels can distort relationships across the coupon stack. Term swaps target valuation differentials between securities issued by the same Agency with different maturity terms. Similarly, inter-agency swaps exploit dislocations in the prices of bonds of the same coupon and term, but issued by different Agencies. There are a variety of relative value strategies that can be utilized in the TBA market, and these tactical trades are able to be effective largely due to the ultra-liquid nature of this market.

Summary

Potential threats facing investors include credit and “liquidity” risk. A fixed-income arbitrage strategy that includes agency relative value is well positioned to meet rising challenges that investors face from increased liquidity concerns while providing alpha opportunities and a low correlation to traditional assets. In the case of the Tradex Relative Value Fund, we believe this ultra-liquid component of our multi-strategy approach will keep our overall liquidity very advantageous in the current environment.

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

FLASH UPDATE: Prepayment Arbitrage - Poised to Benefit in All Rate Paths

While many strategies are buckling under elevated macro volatility, flailing growth in emerging markets, freefalling commodity prices, and concerns over economic stability in Europe, there are specific features of prepayment arbitrage that make it an attractive strategy.

Consistent Risk-Adjusted Return

Carry is the interest earned on our invested assets, and net carry is the interest earned after hedging costs. Investments in US Government Agency prepay-sensitive bonds provide a reliable source of cheap carry with uncorrelated returns to traditional and alternative asset classes. These assets, along with their hedges, are accretive to carry and can provide investors with a predictable source of income while minimizing interest rate exposure.

Why Now?

We are at a pivotal point for our core prepayment arbitrage strategy. The approach, which targets interest payments from home loans, is agnostic as to whether interest rates rise, fall or stay the same due to our unique, market-neutral hedged strategy. If rates stay low or rally further, it would likely correspond with an economic contraction, which means less credit is available for homeowners to refinance. In this environment, credit-oriented strategies have more default risk and would be vulnerable to losses, whereas prepay-sensitive assets would likely benefit from more interest income. Alternatively, if rates rise, our cash flow and carry would also rise and our hedges would protect against the convexity. As homeowners lose their incentive to refinance, our proprietary models would be in a superior position to pick the most attractive securities in an environment of slower prepayments.

An experienced manager should be able to spot mispriced securities and capitalize on the present confusion among market participants. These market conditions present an extremely convex profile that no other asset class provides, making this such an opportune time for our strategy. Furthermore, these securities have become cheaper in recent weeks, with Agency IOs trading at close to two-year wides.

Summary

Surveying the landscape of fixed-income alternatives, to achieve comparable carry to prepayment arbitrage strategies, investors have to extend duration or take on undue credit risk. Hungry for yield, investors were quick to gobble up debt issued by high-yield (junk) companies, many of which were already over-leveraged and on the verge of insolvency. As the cracks turn to deeper divides in corporate credit, Agency IOs will benefit from stronger fundamentals and may exhibit less volatility. A solid understanding based on in-depth modelling of homeowner behavior, will allow astute investors to implement prepayment arbitrage strategies that can outperform regardless of the effect of global-macro conditions on forward interest rate paths.

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

FLASH UPDATE: Sources of Alpha in a Multi-Strategy MBS Portfolio

Overview

Given increases in volatility and uncertainty in the global economic outlook, the rising tide that lifted all ships has given way to tumultuous waves that will pose problems for those who have been simply going with the tide. During the strong bull market from 2009 to 2014, beta exposure was often misclassified as alpha generating strategies. An active, market-neutral approach that combines both strategic and tactical positioning is well suited for generating alpha through exploiting market inefficiencies, while remaining insulated from the ebbs and flows of the market.

Alpha, the most used metric for quantifying risk-adjusted returns, is measured as the difference between the unleveraged portfolio return and passive market exposure. Alpha is a relative metric with roots stemming from modern portfolio theory for traditional investments. However, market-neutral strategies can be thought of as a source of pure alpha since return is provided without benchmark exposure. Alpha can be enhanced through targeted, tactical exposure when market dislocations have created asymmetric return profiles with positive skew. Capitalizing on these dislocations provides tactical alpha through return enhancement and diversification.

The following discussion focuses on the drivers of alpha within the context of a multi-strategy mortgage portfolio.

Prepayment Arbitrage

Prepayment arbitrage, as a fixed-income arbitrage strategy, offers skillful managers a variety of ways to capture alpha in mortgage backed securities (MBS) while hedging out exposure to interest rates (beta). Proprietary models aid mortgage investors in identifying opportunities when a security is cheap, relative to its intrinsic value, by establishing a more accurate view on prepayments and the resultant cash flows than what is priced into the market. Given the varying degrees of sophistication across the heterogeneous mix of MBS investors with differing objectives and constraints, those with superior models are presented with lasting opportunities to capture prepayment arbitrage. Purchasing cash flows that are overly discounted in the market, and intrinsically undervalued, generates a stream of incremental yield (hedge-adjusted carry) that serves as a persistent stream of alpha.

Relative Value Trading

Relative value trading strategies in Agency MBS pass-throughs can provide a pure alpha stream. These securities, which are the second-most liquid fixed income instruments after US Treasuries, can be used for statistical arbitrage and mean reversion strategies that identify and profit from statistically significant deviations from normal market relationships. With the many constituents of the universe of Agency MBS, there are unremitting moments of detachment that can be capitalized upon in tactical, duration-neutral trades. These include the Agency mortgage basis (versus Treasuries or swaps), or pair trades in Agency MBS coupon swaps, term swaps and inter-agency swaps. The return profile in these moments of dislocation is asymmetric and stop loss mechanisms further enhance the distribution to create a program with high-conviction, short-term trades that last from days to weeks.

Opportunistic Credit

Investing opportunistically in Non-Agency mortgage credit allows for a source of alpha, through the disproportionate upside offered at moments of technical dislocations, that result in the mis-pricing of securities. Opportunistic purchases of securities are available to managers who are equipped and poised to act as a liquidity provider to investors seeking to sell at inopportune times (e.g. late in the trading day or low-volume days near a holiday or event). The gap between the purchase price and fair value is a liquidity premium that adds to alpha generation. There are also technical factors such as large liquidations or bursts of origination that can cause certain sectors to become displaced by forces that ultimately abate. Reduced correlations and incremental alpha are the end result.

Summary

Multi-strategy mortgage portfolios are well-equipped to generate alpha in times of increased volatility. By implementing a duration-neutral combination of prepayment arbitrage, relative value trading and opportunistic credit, Tradex aims to provide superior risk-adjusted returns over a full range of market environments. 

We encourage readers interested in learning more about capturing alpha through a mortgage strategies to contact the investment team at Tradex for further discussion.

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

Tradex Global Short-Biased High Yield Fund Ranked #2 Fixed Income - HY Fund in August by BarclayHedge

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

Hedge fund performance as ranked by the BarclayHedge's database