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
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