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
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