Jeff Kong Featured in Wealth & Finance Magazine as Hedge Fund Manager of the Month

Jeff Kong Featured in Wealth & Finance Magazine as Hedge Fund Manager of the Month - please turn to page 18...

http://www.wealthandfinance-intl.com/wealth---finance-june-2016

Opalesque.TV - A Discussion with Jeff Kong: His Top-Ranked Fund Strategy and Why Carry is King

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%

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

The Tradex Global Short-Biased High Yield Fund was ranked the #3 "Fixed Income - High Yield" Fund by BarclayHedge for January. Please see the below award:

This fund was ranked based on the data in BarclayHedge's Database of hedge fund managers

Default-Risk-Adjusted Returns

Fixed income investors interested in achieving enhanced risk-adjusted returns must carefully consider risks, such as prepayment and default, that affect realized yields associated with different types of bonds. In this write-up, we compare the risk-return profiles of Agency and non-Agency securities as well as corporate debt obligations. We find that Agency Interest Only (IO) securities have historically provided investors with higher carry at reduced levels of risk relative to other fixed income products. Non-Agency IOs may also offer good investment opportunities, but this depends on market spreads and the quality of prevailing underwriting standards. In recent years, these standards have greatly improved from those used during the Financial Crisis. When compared to Agency and non-Agency securities, corporate debt obligations offer suboptimal risk-adjusted returns. Corporate bonds also require investors to perform laborious underwriting to understand fully their vulnerability to default. Our analysis indicates that Agency IOs offer a unique risk-return profile for fixed income investors by providing the security of US Government backing at higher yields than US Treasuries. 

Agency Securities

Defaults in Agency IOs are termed involuntary prepayments. These occur when a borrower stops making payments and the Agency (i.e. Fannie Mae, Freddie Mac, Ginnie Mae) must step in to pay back (i.e. prepay) the balance of the principal of the government guaranteed loan. Fannie and Freddie Mac report the default rates on loans underlying selected Agency securities. These involuntary prepayments are measured by the Constant Default Rate (CDR), which is the annualized percentage of principal involuntarily paid off via default. We find that the average annualized CDR from January 2000 through June 2015 (the most recent data) was 0.84% for Fannie Mae and 0.82% for Freddie Mac, as shown in Chart 1. During the height of the Financial Crisis, Fannie and Freddie bonds had annualized CDRs of 3.34% and 3.11%.

Chart 1: Agency CDRs

Non-Agency Securities

Non-Agency deals are issued by banks. They are often constructed with several different tranches, each with its own distinct level of exposure to credit risk. Loan-level detail analysis is often necessary to understand fully a particular security’s exposure to default risk. As observed in Chart 2, default rates vary widely depending on a security’s collateral quality as Prime, Alt A, or Subprime. From 2011 through 2015, average CDRs were 2.89% for Prime, 5.90% for Alt A, and 7.58% for Subprime. 

Chart 2: Non-Agency CDRs

We believe Non-Agency securities may offer attractive risk-adjusted returns, depending on where we are in the credit cycle and the quality of underwriting practices. However, since these conditions vary, we maintain an opportunistic approach to Non-Agency credit. Recently, we have consciously avoided investing in Non-Agency securities as yields are relatively tight, though we are always on the lookout for when the timing may be right for credit exposure. 

Corporate Bonds

When compared to Agency and Non-Agency securities, corporate bonds do not have attractive default-risk-adjusted returns. This is in part due to the difficulty involved in understanding credit exposure in corporate debt, which requires investors to perform laborious underwriting. Moreover, this time-consuming analysis still does not insulate investors from the idiosyncratic risk inherent in bonds issued by a single company. Agency and non-Agency securities benefit from diversification, since each bond is backed by hundreds, if not thousands, of individual loans. In addition, it is important to not be fooled by the purportedly low number of “Investment Grade” (AAA through BBB-) defaults, because these numbers do not include the so-called “fallen angels”, which are companies that were downgraded prior to going bankrupt.

Yield Comparison

Having examined default rates, we now turn to yields in our discussion of risk-adjusted returns across fixed income assets. The yields typically found in Agency IO securities range from 5 to 6%, while non-Agency RMBS usually yields around 5-7% , and High Yield corporate bonds (unadjusted for default) may yield 7-10%. It is important to note that the yields for High Yield bonds assume all cash flows are realized with no defaults, which explains why they are often greater than Agency IO yields. Also, non-Agency securities may typically have higher yields than Agency IOs at the cost of illiquidity, credit exposure, and longer periods until the return of capital. In light of this, the 5-6% yields one can expect from Agency IO strategies represent an outstanding risk-reward profile. 

Another factor in assessing the attractiveness of a fixed income investment is the capital requirement. Corporate bonds require investors to put up a relatively large amount of capital for a semi-annual coupon and a principal amount that is not returned until the bond matures, usually in 10 years or more. In the case of Agency IO securities, investors purchase a stream of monthly interest payments that tend to be front-loaded. As such, capital is returned at a much faster rate, often offering a more attractive yield over a shorter timeframe. Thus, for fixed income investors, Agency IO securities can offer yet another advantage over corporate debt and US Treasuries.

We find there are many sound reasons for investors to have exposure to Agency and non-Agency securities. The Tradex Relative Value Fund primarily invests in Agency securities in a market-neutral portfolio that seeks attractive absolute returns. As previously mentioned, we may, at times, invest opportunistically in non-Agency securities, if the conditions are right for us take on credit exposure. We aim to hedge interest rate risk by maintaining a near-zero duration book along with superior loss-adjusted returns. This market-neutral strategy has delivered enhanced risk-adjusted returns for our investors, offering competitive yields and generous carry with limited downside.

We recommended readers interested in learning more about the Tradex Relative Value Fund’s strategy to contact InvestorRelations@TheTradexGroup.com.  

Tradex Global Short-Biased High Yield Fund Ranked #7 Fixed Income - HY Fund in 2015 by BarclayHedge

The Tradex Global Short-Biased High Yield Fund was ranked the #7 "Fixed Income - High Yield" Fund by BarclayHedge for 2015. Please see the below award:

This fund was ranked based on the data in BarclayHedge's Database of hedge fund managers

Capturing Price Movements in a Volatile Market

2016 is off to a rocky start, yet amid this market turmoil there exist great investment opportunities in prepay and relative value strategies. We have found that events of significant spread widening present real opportunity as historically, reversion happens rapidly. In the case of structured rates products such as Agency pass-through securities, it may be only a matter of days or weeks for the distorted price relationships between securities to revert to their historical norm. The slightly longer-to-recover prepay-sensitive bond spreads often revert within a quarter. As such, we are of the opinion that because the due diligence and allocation process can be arduous, it would be difficult to time an allocation to attempt to capture a specific event. Rather, since the strategy is interest rate neutral and provides a strong yet stable carry profile, an ongoing investment would be better suited to take advantage of these temporal opportunities. The culmination of these sources of returns leads to a projected asymmetric return profile.

Prepayment arbitrage, Tradex Relative Value’s core strategy, can offer a uniquely asymmetric return profile in most market environments. Given our tactical use of leverage and cash management practices, outsized spread widening events can be treated as buying opportunities as other investors are squeezed for liquidity and sell into fear. As illustrated below, we have found that spread widening events are often transient precede longer periods of spread tightening. In such circumstances, leverage and excess cash can be used to purchase cheap cash flows. We have observed this reversion effect many times over, and have built in processes to take advantage of such circumstances. Please see the chart below:

 

Example 1

Another significant spread widening event occurred following the surprise Mortgage Insurance Premium (MIP) cut in January 2015. The Federal Housing Agency (FHA), which provides mortgage insurance on loans made by approved lenders, cut the MIPs by 50 bp, thus creating a refinancing incentive for borrowers and leading to increased prepayment expectations. Spreads widened as a result, presenting an attractive trading opportunity that was quickly exploited within weeks. Our strategy successfully capitalized on this event by buying undervalued bonds in February 2015 and delivering 2.11% (net) that month.

 

While transient spread movements present opportunities to capture spread tightening, the high cash carry component inherent in the strategy and active hedging insulate the portfolio’s assets from large losses in these times of volatility, contributing towards the natural asymmetry of the strategy. Furthermore, compounding carry over a period can drive significant returns.

Not unlike the prepayment component of our strategy, relative value trading can provide similar opportunities. However, given the nature of relative value trading and liquidity of TBA markets, opportunities are often more numerous, yet the window in which to catch outsized movements is often smaller.


Example 2

One such example is the MIP cut, which presented a profitable trading opportunity to short the Ginnie II vs Fannie 4.0 agency swap. This dislocation lasted no more than a few weeks, and it was available only to those already invested in the Fund. We have regularly observed similar relative value trading opportunities in coupon swaps since the MIP Cut.

Example 3

Another illustrative example of a relative value trading opportunity was the basis widening that occurred during the 2013 Taper Tantrum, when the Fed suggested it may taper its QE program. During the Tantrum, the basis sold off between 1 and 4 percentage points and presented an excellent buying opportunity. The tightening rebound following the tantrum was around 2 months.

Summary

The Tradex Relative Value Fund utilizes its multi-strategy approach to capitalize on events when spreads widen and then subsequently tighten. Our Core Carry Strategy seizes these opportunities to invest in undervalued bonds, and our RV Strategy exploits these dislocations through opportunistically trading Agency pass-throughs against one another and against other rates products. We anticipate spread movements will offer many attractive investment opportunities in 2016, especially given the uncertainty in Fed policy and the instability of the global economy. We look forward to taking advantage of these events on behalf of our investors.

Story Time with Tradex: Understanding Mortgage Cohort “Stories”

Story Time with Tradex: Understanding Mortgage Cohort “Stories”

Not all mortgages are made the same. Some mortgages are small, and some are large. Others are young, and others are old. Some are rich and some are poor. In this brief write-up, we attempt to clarify common mortgage collateral stories and the anticipated effects on prepayments and valuation.

While most fixed income products have known cash flows, mortgage backed securities do not because they are dependent upon homeowner behavior that can be difficult to predict. Each month, a homeowner faces a choice of paying, refinancing, or defaulting on the mortgage. While these decisions should be relatively easy to predict based on rate incentive, empirical evidence suggests that borrowers do not always act rationally to maximize economic utility, making prepayment analysis both a behavioral and economic study. Since thousands of loans are pooled into a single pass-through, the law of large numbers should in theory reduce noise from irrational homeowner actions, or lack thereof. However, certain ‘cohorts’ of homeowners may collectively act in an irrational manner. The stratification of homeowner characteristics into a single security often facilitates prepayment analysis.

Collateral Story Proliferation

Following the financial crisis, the FHFA developed the HARP program[1] to help American homeowners refinance into mortgages with more affordable monthly payments. This program eventually led to an exponential growth of collateral stories, and increased the knowledge necessary to accurately value and anticipate these cash flows. Examples of story collateral include MHA Program (HARP), loan balance, seasoned, geographic exposure, mortgage purpose (relocation, investor, etc.), FICO, Third Party Origination, and many others. These collateral types will often exhibit prepayment behavior that vary from their generic counterparts due to differing degrees of refi sensitivity.

HARP Program

In March 2009, the FHFA introduced the Home Affordable Refinance Program to, “provide access to low-cost refinancing for responsible homeowners suffering from falling home prices¹.” The program allowed responsible homeowners to refinance their loans despite having loan to value (LTV) ratios above 80%. Simply stated, as home prices fell, LTV ratios increased dramatically and homeowners could not take advantage of falling mortgage rates due to low or negative home equity. The HARP I and II programs served as a remedy to this issue and led to a meaningful increase in prepayment speeds on HARP eligible collateral. Many of these HARP loans were subsequently securitized into a new pool and designated as “MHA 80”, “MHA 90”, etc. pools. Investors viewed these pools as call protected[2] since a borrower who refinanced under the program would be ineligible to access the HARP program again. Initially, these pools carried lower risk premium. However, as home prices rebounded and LTVs fell, the pools began to prepay faster as mortgage rates remained low.

Loan Balance

While the average loan size in a new mortgage is approximately $268k[3], some pools are composed of loans whose original size is below 85k, while others are greater than 417k. The first case, “LLBs”, are Low Loan Balance pools. Investors often view LLBs as call protected because the total dollar savings of refinancing is less on small loans. These homeowners are thus less likely to refinance and, in theory, LLB pools should have more stable and predictable cash flow. The result of lower expected prepayments and greater degree of cash flow predictability leads to higher relative valuation and smaller risk premium. This collateral type is often highly desirable when interest rates decline. On the other end of the spectrum, Jumbo loans will have higher dollar savings than smaller loan balance collateral given the same rate incentive. Thus, bonds backed by Jumbo loans often have a larger risk premium as those borrowers have greater incentives to refinance.

Seasoned (burnout)

Collateral seasoning refers to the age of the underlying loans in a mortgage pool. Most new loans have mortgage rates that are at or around prevailing market rates and those borrowers have no rate incentive to refi. Post origination, mortgage rates will change as bank borrowing costs increase or decrease. Over time, a mortgage pool may experience periods in which homeowners have significant incentives to refinance. Many borrowers will refinance and will exit the pool. What remains is mortgage loans that have above-market coupons that are deep in the money. For some reason, the homeowners remaining in the pool have not refinanced their loans despite the financial incentive to do so. We often refer to this phenomenon as burnout, and this seasoned collateral tends to have a muted response to increases in refi incentive. Furthermore, seasoned collateral often has a steady prepayment profile and investors often place a low risk premium on this collateral type.

Geographic Exposure

The colloquialism, “all politics is local” comes to mind when considering the geographic distribution of underlying mortgage loans. While economic activity is often summarized at the US level, this economic activity is an amalgamation of local economies at the MSA (Metropolitan Statistical Area) and state level. Some of these economies may be expanding, while others may be shrinking. This activity directly affects borrowers’ income and home value, ultimately affecting prepayment behavior. Geographic stories, or “GEOs” for short, typically contain 100% borrowers from a certain state, such as California, NY, TX, etc. California borrowers tend to be more sophisticated and own larger homes. Thus, they are highly sensitive to rate incentives. CA bonds typically carry a higher risk premium than say, NY, TX, or PR (Puerto Rico) bonds. When investing in GEO stories, it is prudent to be aware of homeowner and mortgage attributes as it directly influences cash flow. For example, recent declines in oil prices has negatively impacted shale states’ economies. This may translate into lower HPA, less turnover and muted refinancing incentive.

Conclusion

In the wake of the financial crisis, the number and complexity of collateral stories has significantly increased. As a result, investment managers must be cognizant of the various collateral types and have an understanding of how they affect prepayment behavior and MBS valuation. While this editorial provides some clarification of collateral stories, we encourage our readers to research mortgage collateral stories further and to have a dialogue with the investment team at Tradex.

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

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[1] Collectively HARP I and HARP II. https://www.fanniemae.com/singlefamily/making-home-affordable

[2] Call protection refers to the call option held by the homeowner. If prevailing mortgage rates are lower than a homeowner’s mortgage rate, the homeowner may exercise the call option and refinance into cheaper loans.

[3] MBA US Conventional Refinance Average Loan Size Index

Tradex Global Short-Biased High Yield Fund Ranked #1 Fixed Income - HY Fund in November by BarclayHedge

In November, the Tradex Global Short-Biased High Yield Fund was ranked in the Top 10 for the 5th time in the last 6 months by BarclayHedge, this time appearing as the #1 "Fixed Income - High Yield" Fund. Please see the below award:

This fund was ranked based on the data in BarclayHedge's Database of hedge fund managers

Tremors: The Evolution of a Short High Yield Strategy

The current high yield (HY) bubble can be thought of as an impending earthquake that is severe in magnitude and warning local inhabitants with foreboding tremors. We have been discussing the state of the HY market with investors for approximately two years now, shooting up flares and ringing alarms, like these communications in December 2013 and March 2014 (before and when our short strategy launched). The basic investment thesis has been that there are hundreds of companies that have had near unfettered access to capital markets due to unprecedented easy-money policies. Many of these companies did not merit this access, but nevertheless it was still cheap and easy for them to find refinancing or to issue new debt. These companies probably knew that at some point capital markets would become much harder and more expensive to access. The tremors are now much closer to each other and carry much more force, as we wind down a year that will result in the first annual HY loss since 2008. The “worst-of-breed” HY companies that we target are becoming easier to find, because there are so many of them. In this blog, we will review the evolution of a short high yield bond strategy in recent years.

City-life is bustling – 2009 to 2012: The Financial Crisis is over and companies that barely made it out of 2008 have licked their wounds. Helicopter Ben is QE’ing like crazy and capital markets are open for business. High yield companies have access and can raise large amounts of low-cost debt.  What do they do with it?  They extend their Ponzi-schemes by refinancing prior debt, by paying out dividends, by initiating expensive share buy-back plans and by making ill-advised acquisitions and LBOs.  In CCC’s, less than 10% of new bond issuance is used for corporate purposes, CAPEX or project finance.

Seismic activity deep underground – 2012 to 2014:  CCC’s that hung on in 2008 and levered up afterwards are seeing their businesses grind slower, with huge amounts of new competition, negative revenue trends, volatile EBITDA, declining and negative free cash flow and rapidly increasing levels of leverage.  Refinancing activity reaches fever pitch levels in 2014, accounting for 33% of all CCC new issuance activity by purpose.  The companies need breathing room and they need it fast. Yield-to-worst in the JPM US HY Index hits 5% as the Fed has indirectly forced investors into taking undue, credit-agnostic risk. Some HY companies secretly hope that they find a seat before the music stops. Seismic activity is starting to be registered, some small tremors are felt and some early adopters reduce exposures and start to prepare for the coming quake. 

A tectonic shift occurs – 2014 to 2015:  Macro headwinds persist and are being recognized and pointed out by many well-known market participants.  The inevitability of the cyclical nature of markets looms large – equity markets are tired and overextended, commodity markets are shaky and need EM growth to sustain, high yield markets are frothy. Famous market mavens are warning the masses. An interest rate hike is imminent and the Fed’s level of conviction is not confidence-inspiring. Over the last 43 years, on average, 56% of CCC issuance defaults within 7 years of issuance. The time is up. As flows turn negative, volumes recede, new issue activity slows, liquidity dries up and performance turns negative, can this time really be different?  As Mark Twain famously said, “History does not repeat itself, but it rhymes”.

Evacuation plans are put into effect – 2015 to TBD:  The tremors are no longer subtle and the fault lines are apparent. The collapse in oil prices has global impact, effecting commodity pricing across the spectrum, threatening employment gains, failing to positively incentivize the consumer to spend more and raising geopolitical tensions.  Bankers, who have plenty of choices for raising debt, recognize that capital markets are no longer quite as accommodative and choose safer borrowers to bring to market. Risk reassessment occurs overnight, repricing certain sectors such as telecom, cable and chemicals (ie. Sprint, Cablevision/Altice and Olin/Dow Chemical, respectively).The constant push and pull between bulls and bears is starting to shift to the bear side and liquidity is tested. 

Destruction followed by rebuilding – TBD:  The inevitable earthquake occurs swiftly, and companies will be torn down. Default rates have spiked and distressed players start looking for reclamation projects. This is a great time to be a long distressed buyer, but before that becomes a viable option, there will be lots of pain taken.

There is still time to get short of high yield bonds at asymmetric price levels. But, once the tipping point is crossed, market dynamics shift quickly and these bonds can no longer be borrowed. We have already established shorts near par in preparation for the earthquake in HY. This strategy is clearly an opportunistic one, and now is the time to protect a portion of your portfolio. Good luck out there.  #shortHY

Richard Travia,

Partner, Director of Research

The Tradex Relative Value Blog Series

Our latest research series considers relative value fixed income investment strategies that are liquid, market neutral and consistently produce alpha. We believe investors’ chief concerns include a changing U.S. interest rate policy, mitigating risks away from credit exposure, and maintaining liquid positions given the potential for increased volatility. In light of the current market environment as well as managerial constraints and goals, we outline a multi-strategy approach that touches on the above-mentioned environment and concerns.

Sources of Alpha in a Multi-Strategy Fixed-Income Portfolio

Overview

Given the recent increase 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. Alpha, the most frequently 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. During the strong bull market lasting from 2009 to 2014, beta exposure was often misclassified as alpha in fixed income 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. 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 fixed-income portfolio.

Prepayment arbitrage of Agency structured bonds, as a fixed income arbitrage strategy, offers a variety of ways to capture alpha in structured products while hedging out exposure to interest rates (beta). Proprietary models aid US Government Agency investors in identifying opportunities when a security is cheap, relative to its intrinsic value. This is accomplished 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 fixed-income 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 strategies in Agency pass-throughs can provide a pure alpha stream while investing in liquid securities. 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 bonds, there are unremitting moments of detachment that can be capitalized upon in tactical, duration-neutral trades. These include the Agency basis (versus Treasuries or swaps), or pair trades in Agency 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.

Investing opportunistically in Non-Agency structured credit allows for a source of alpha, through the disproportionate upside offered at moments of technical dislocations that result in the mispricing 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.

Multi-strategy fixed-income 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. 

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.

Prepayment sensitive securities are unique in that what drives fundamental performance is the behavior of individual homeowners. Every month, each homeowner faces the choice as to whether to continue to pay, to refinance, or default on their loan. This choice will be greatly influenced by such personal factors as household income, localized home prices, loan balance, and credit score, among others. These behaviors inevitably drive security cash flows, and thus performance of prepayment-sensitive securities.

While prepayment models have been developed to predict these behaviors, homeowners do not always act to maximize economic utility and so there are sources of model error. This is especially true for models that attempt to predict prepayments for large sectors of the market. Finely-tuned prepayment models are better equipped to project future cash flow and determine the relative rich or cheapness of a security. A manager that focuses on prepayment arbitrage must fully understand borrower behavior, market technical factors, and model projections.

A prepayment arbitrage strategy focuses on the market-implied behavior relative to the “delivered” behavior.
To accomplish this, a manager must actively manage the portfolio with respect to prepayments to understand the sources of risk in prepayment-sensitive securities, and use liquid instruments to neutralize unwanted risks. The excess spread captured in a market-neutral prepayment arbitrage strategy can be thought of as pure alpha, as the returns generated typically exhibit minimal risk and a predictable source of carry. Another significant benefit of the prepayment arbitrage strategy is that the hedges are typically accretive to carry, which improves the already significant cash-on-cash yield.

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, can provide investors with a predictable source of income while minimizing interest rate exposure.

Why Now?

The approach, which targets interest payments from home loans, is agnostic as to whether interest rates rise, fall or stay the same given its hedged, market-neutral nature. 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. Alternatively, if rates rise, we expect carry would increase due to lower prepayment levels. As homeowners lose their incentive to refinance, superior prepayment modeling would be in a position to pick the most attractive securities in an environment of slower prepayments.

There are opportunities to spot mispriced securities and to capitalize on the present volatility. Global events including disinflationary pressures abroad, and a domestic Fed poised to move away from its Zero Interest Rate Policy, makes this an opportune time to exploit relative mispricing in prepayment-sensitive securities. Surveying the landscape of fixed-income alternatives, investors have extended duration or have taken on undue credit risk in this low interest rate environment to achieve returns. As other markets begin to appear close to fully priced, prepayment arbitrage strategies will likely exhibit less volatility while producing a stable source of return. The in-depth modelling of homeowner behavior that informs prepayment arbitrage strategies enables them to outperform and capitalize on uncertainty.

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 bonds, 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 pass-through 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 bonds 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 which can be capitalized on 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 in this space. Agency basis trades typically exploit moments of detachment in the pricing of Agency 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 can be effective largely due to the ultra-liquid nature of this market.

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.

What's Next in Credit

Following the 2008-2009 financial crisis, credit-sensitive securities experienced unprecedented spread widening as investors lost confidence not only in homeowners’ ability to repay mortgages, but in housing finance altogether. Being short of credit-sensitive securities during this period and subsequently purchasing over-penalized securities provided exemplary opportunities to generate outsized returns. Having navigated the Big Short and the Big Recovery, the Tradex team has adopted an opportunistic sub-strategy that is capable of taking advantage of such outsized market moves. While the Big Recovery has all but ran its course, there are a few sectors worth watching in the current credit cycle.

GSE Credit Risk Transfer (CRT) 

Government-sponsored enterprises (GSEs), like Fannie Mae, Ginnie Mae and Freddie Mac, issue credit risk transfer (CRT) bonds to transfer a portion of credit risk on mortgages they guarantee to private investors. Such a transfer has the added benefit of diversifying credit risk among several investors, as opposed to concentrating it in the hands of GSEs. Spread widening and risk-off sentiment has pushed CRT spreads wider and the credit curve steeper.  At the same time, the housing market continues to recover and the current low interest rate environment (i.e. low refinancing incentive for borrowers) remains supportive of fundamentals.  While there is value across the CRT space as a whole, we see the best risk/reward in the last cash flow (LCF) tranches. These classes have benefitted from strong housing fundamentals, resulting in homeowner balance sheet deleveraging due to strong prepayments and low defaults. With spreads 450 to 500 over swaps and spread durations of 7 to 8 years, we see this sector as having the potential to return 7 to 10 percent over the next year with strong carry and modest roll-down/spread tightening. Issuance of CRT remains strong and by all accounts, the market is here to stay.

Non-QM 

The qualified mortgage (QM) rules opened the door for private investors to originate non-qualified mortgages, and these loans are now becoming a factor in the RMBS market. Lenders are currently seeking access to the securitization market, after reshaping the credit box to provide financing to creditworthy borrowers who were left out by the restrictive QM regulations, such as a debt-to-income ratio of 43% or less. In September, Loan Star issued a $72 million transaction that stands as the first transaction secured primarily by non-QM loans. The M1 tranche of that transaction has 6% of credit support and bears a 6.8% coupon. We expect more deals like this to price, offering potentially attractive investments in the credit space that can be exploited opportunistically.

CMBS 

While there are pockets of opportunity in the legacy CMBS market, most securities are priced to optimistic scenarios. Legacy CMBS bonds are also running off quickly as we navigate the 2015 – 2017 maturity wave.  Going forward, CMBS 2.0/3.0 will likely provide tactical and strategic opportunities to investors who are able to discern between the various loan pools. In-depth analysis is key to security selection for finding misunderstood pools that may not be priced to optimistic scenarios. CMBX tranches also provide investors with a liquid means of expressing positive or negative views in this sector. At present, the BBB tranches look attractive after suffering during the global rout in August and September. The 2.0 BBBs trade at spreads in the mid-300s over swaps with average lives of 6 to 7 years.  New issue 3.0 BBBs carry more spread duration with WALs of 9 to 10 years, but trade with spreads closer to 500bp over swaps.  At current levels, these securities yield 5 to 7% and offer good carry with fixed rate coupons. As we pass through the 2015-2017 maturity wave, loan demand and issuance will begin to taper, resulting in technicals that are supportive to spreads. The present situation in CMBS may be prime for investment managers with cash holdings and deep knowledge of the space to opportunistically navigate the coming quarters.  

Overall, the potential opportunities in mortgage credit make this investment space interesting for early adopters equipped with the expertise and cash on hand to take advantage of what’s next.

Summary

As fixed-income investors consider liquidity risk and changes in the Fed’s zero interest rate policy, the need for investment strategies that are liquid and market-neutral becomes clear. This series examines sources of alpha and interest-rate-neutral trading strategies within the context of a multi-strategy fixed-income portfolio. The Tradex Relative Value Fund manages such a strategy, where it seeks to capitalize on opportunities in prepayment arbitrage, relative value pass-through trading, and opportunistic structured credit. We believe our multi-strategy approach will provide investors with alpha generation as well as liquid positions that are market-neutral and can deliver strong risk-adjusted returns.

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global