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

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

FLASH UPDATE: What's Next in Credit

What’s Next in Credit

As credit sectors post lackluster returns and the residential mortgage backed securities (RMBS) market normalizes, many market participants are left to determine what lies ahead in mortgage credit investing.  With this blog, we share our perspective on potential opportunities in mortgage credit.

The heightened volatility experienced in Q3-2015 has affected several sectors in both equity and fixed-income investments. Although real estate fundamentals remain strong, non-agency RMBS have experienced spread widening alongside high yield and other risky assets – albeit less severe. While the flat to low-single-digit YTD returns posted by many mortgage credit hedge funds is favorable in comparison to those of other strategies, it highlights the notion that the double-digit returns witnessed the last five years are likely a thing of the past.  This shift in outlook has forced mortgage credit managers to pursue other potentially higher returning and riskier opportunities in mortgage credit. 

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, and the housing market continues to recover and the current low interest rate environment (i.e. low refinancing incentive for borrowers) remain 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.

NPL/RPL – Non-performing loans (NPL) are those for which the debtor has not made his or her scheduled payments for at least 90 days. Consequently, the odds that these loans will be repaid in full is substantially reduced. Re-performing loans (RPLs) include NPLs where the debtor has started to make payments again. Overall, we view the market as vibrant given NPL and RPL residential whole loan issuance is starting to pick up, having reached over $20 billion thus far in 2015.  Yields are in the mid-single digits for relatively short average lives (2 to 3 years) and the bonds are often over-collateralized with strong underlying fundamentals.  With nearly $500 billion of collateral on GSE and financial institution balance sheets, we anticipate that loan sales will increase, as will subsequent securitizations.  Given the size of the pipeline, NPL/RPL remain a viable avenue for relatively steady mid-single digit returns for early adopters of the asset class.

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 now 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 ratios 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.  

Single Family Rentals (SFR) – Containing features of both RMBS & CMBS, this component of the mortgage credit universe will remain relevant due to homeownership trends.  The overbuilding and rise in homeownership rate during the boom has led to the creation of a viable single-family rental asset class.  These securities currently offer an early adopter advantage and the sweet spot in the capital structure from a risk/return perspective is the single-A and BBB part of the stack.  Spreads range from 300 to 450 over swaps, depending on the shelf and tranche, assuming the 2yr base-case WAL that most deals carry. We see this as another opportunity for credit investors to capitalize on the sector’s evolution in the near to medium term.   

Summary

Mortgage credit sectors have undergone structural changes that make this space attractive to astute managers armed with cash holdings and the flexibility to strike opportunistically. Going forward, strong residential and commercial real estate fundamentals will likely support strong performance in GSE CRT, NPL/RPL, Non-QM and SFR securities. In addition, knowing how to re-underwrite CMBS deals will enable active managers to reap benefits from in-depth analysis of targeted loan pools.  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.

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global