IOs: A High Yielding Alternative

We outline key features of the Tradex Relative Value Fund’s market neutral portfolio of Agency backed Interest Only (IO) and Inverse Interest Only (IIO) securities. Such a hedged portfolio may deliver attractive, stable returns, which can be enhanced with conservative use of leverage. A key component of this strategy’s stability is the high level of reliable carry it earns, which can be in excess of 50bp per month on an unlevered basis. Interest rate exposure can be hedged to protect this income stream. Hedging dynamically can generate interesting relative value trading opportunities as a potential source of alpha. Furthermore, a large cash position is maintained to opportunistically capitalize on market dislocations as they arise. 

The Tradex Relative Value Fund’s (TRV) annualized net performance was 3.63% with a Sharpe ratio of 1.56 since inception (the period January 2015 through February 2016). To-date we have used no leverage, but we expect to tactically utilize leverage in the future.

In the table below, we compare these results with the performance of high yield bonds, and fixed income arbitrage hedge fund strategies. Fixed income investors targeting high single digit returns may find using conservative levels of leverage on a hedged portfolio of Agency mortgage-backed securities is an attractive investment opportunity when compared to these alternatives. Hedging interest rate risk is especially beneficial to investors given the uncertainty surrounding Fed policy. 

Furthermore, Agency mortgage-backed securities are implicitly guaranteed by the US Government, which makes them unique among fixed income instruments in that they do not have credit exposure and yet they offer higher yields than Treasuries. The combination of these factors creates a generous and dependable income stream for investors in this strategy.

Performanceƚ
	TRV	HYG	HF FI Arb
Annualized Return (unlevered)	3.52%	-4.4%	-1.0%
Standard Deviation	2.20%	6.3%	1.8%
Sharpe Ratio*	1.56	-0.71	-0.60
ƚ TRV net returns
HYG: Adjusted returns for iShares iBoxx $ High Yield Corporate Bd
HF FI Arb: DJCS Hedge Fund Index Fixed Income Arbitrage
* Risk-free rate of 1 Month LIBOR at 0.31%