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

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.  

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: 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

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