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

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

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: Global growth concerns add to uncertainty surrounding Fed liftoff

TRV Mid-Month Commentary | August 2015

Comment:
The news cycle for the first half of August has been dominated by global growth concerns following the People’s Bank of China’s surprise decision to devalue the Yuan that resulted in the largest one day decline in two decades. Global markets largely saw the move as a play to increase export activity, spurring fears of a decline in global growth that set the tone for a risk-off mentality.

Global economic concerns have also caused investors to contemplate whether the Fed will move in September, and July’s change in Non-Farm Payrolls provided little guidance to potential Fed policy as the numbers came in at expectations. We note that the market has turned more bearish on a September hike as the Fed Funds futures market implies a 36% probability of such an occurrence[1], down from near 50% a few weeks ago. Although the Fed’s most recent Dot Plot[2] implies two hikes in 2015, we are less certain of this outcome following recent news.  Despite the uncertainty surrounding a September hike, 10yr yields managed to increase 2 bps to 2.18 while 5yr yields increased 7bps resulting in a 5bp 10/5 bear flattener.

In this backdrop, securitized credit faced headwinds as spreads were pushed wider and weaker credits underperformed due to a steepening of the credit curve.  While weakened sentiment regarding the global economy has had an impact on the credit instruments, the US housing and economic fundamentals remain supportive.  We view these dips as buying opportunities with the expectation that fundamentals will ultimately drive spreads tighter.  At current levels, there is value in last cash flow tranches of GSE credit risk transfer bonds as well as in BBB-rated single family rental securitizations.  Non-traditional ABS such as aircraft, NPLs, and marketplace lending transactions offer incremental yield and have weathered the recent volatility quite well due to strong investor demand.

Recent market action and the risk-off sentiment has likewise affected hedged return on the mortgage basis: hedged with 5yr Treasuries, premium 4.0s widened 2 ticks, while widening 8 and 5 ticks versus the 10yr and Treasury Curve hedges, respectively. Premium 4.5s, however, performed poorly against bullet and curve hedges having widened between 7 and 10 ticks. Since August 1^st, the basis has cheapened between 5 and 9 ticks owing to deteriorating rolls, low level of rates and diminishing bank, oversea and REIT demand. We consider the timing may perhaps be ripe for a tactical long position, but our long-term view leans much more bearish. We tread cautiously at this juncture and look to September for clarity.

Since the end of June, we note that the mortgage rate has fallen 27 bps and that the refi index continues to climb from its June low. That said, we expect a 5-10% decline in prepayments from July to August on lower turnover and refi activity, particularly for cuspy 3.5s and 4.0s of 2013 & 2014. While this sounds counterintuitive, it is important to mention that the Refi Index is a leading indicator and refi applications take some time to work its way through the pipeline. Over the last couple of months, option-adjusted spreads on IOs and Inverse IOs have remained relatively stable. However, a surprise decision from the Fed could temporarily cause spreads to dislocate and provide advantageous volatility.

As September looms, we continue to find pockets of opportunity in our markets but remain cautious due to potential knee-jerk reactions. Overall, we think the coming months will yield abundant opportunity.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

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[1] http://bit.ly/1DtLVLk

[2] http://1.usa.gov/1LfLfSK