FLASH UPDATE: TRV Weekly Commentary - Impact of Duration & Convexity

TRV Weekly Commentary
Week Ending 11 Nov 2014

Comment:

Rates continue to rise following last month’s sharp rally leaving the 10yr 2 bps higher at 2.36. We’ve also seen implied volatility on the 1Mx10YR swaption declined to 69 bps. Investors’ comfort with risk assets has led the mortgage basis to continue to tighten to 139 bps –2 bps tight to our regression model, although 2bps is within the standard error of the model. We continue to expect the basis to widen, as the burden of absorbing supply will increasingly be on private investors i.e. non-Fed purchasers.

The minimal rise in rates had a small impact on the refi index as it closed down 31 points to 1590. Although we expect rates to rise in the near future, investors are pricing in higher refis as OAS on benchmark IOs continued to widen. Most notably, premium 4s and 4.5s of 2010 widened the most this week by 11 and 17 bps, respectively. If rates continue to drift upward and volatility remains low, we would expect these coupons to tighten in terms of OAS. A trade to express such a trend would be a premium/discount IOS swap.

Given a rise in rates and decrease in vol, we would expect to see spec pool payups to fall. Our expectations are generally in line with spec pool prices; loan balance decreased across the coupon stack between 1 and 4 ticks while LTV stories decreased in premium 4.5s between 2 and 12 ticks as seen in LTV>105. With rates increasing steadily, we prefer TBA versus spec for the time being.

Noteworthy:

This week, we look at convexity risk on 2010 IO trusts. Given today’s rate, spread and prepayment environment, the entire 2010 IO stack displays negative duration. The benefit to negative duration IOs is that the interest rate exposure can be hedged by purchasing TBAs – a strategy that typically exhibits positive carry. The chart below shows that a sizeable rate movement is required to bring the IOs into positive duration territory. For the time being, we foresee carry remaining positive. While negative duration is beneficial to an IO/TBA carry strategy, IOs are at their lowest point of convexity. In other words, duration is at its most sensitive position with respect to rate movements and hedging costs may increase as rates move.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

IO Duration and Convexity

FLASH UPDATE: When will the Big Fish Hit?

The fisherman carefully baits his line and casts it into the perfect spot.  He patiently waits, because he knows that big fish come by this spot regularly.  He doesn't panic, rather the wait makes him feel a certain sense of inevitability.  His decades of experience remind him that this series of actions almost always results in a big catch.   He is not concerned that no other fishermen know how prolific this hole has been.  He notices his bobber get pulled under briefly, but it pops up again...he remains patient...Again the bobber goes under, but it seems like just a nibble and it comes up to the surface...he remains patient but his anxiety starts to build...The bobber goes under for a third time, but the feel of the line is familiar this time and suddenly the reel starts to empty...FISH ON! 

We are getting multiple opportunities to add to our short high yield positions at asymmetric price levels.  Since July, volatility in the high yield market has picked up considerably, with both positive and negative swings.  This is our bobber...We are still able to short significantly challenged companies at prices above par and at or near the call price.  The opportunity is here and now.  

What is most interesting is that we have seen this many times before:  volatility picks up, sensational headlines start to draw attention, bond prices start to feel shaky and companies start to falter.  Our many years of experience make this feel like a repeated pattern of events.  The outcome is predictable, but the route to get from start to finish often provides exciting new experiences.  It is the exciting new experiences that take most stragglers and tourists out.  The yield-chasers will be burnt.  We know that we will survive those exciting new experiences, but are you prepared?   

Have a nice week,

Richard Travia

Portfolio Manager, Director of Research

FLASH UPDATE: TRV Weekly Commentary - Vol Forthcoming

TRV Weekly Commentary
Week Ending 28 Oct 2014

Comment:

As of week’s end, rates are 20 basis points lower month-over-month, although the route here was anything but gradual. The UST 10-year yield reached an intraday low of 1.87 on October 15th and has since retraced approximately 70 percent of the peak to trough distance. With the Fed officially ending its Treasury purchase program, we begin to see signs of market volatility.

In addition, future market volatility may be exacerbated by decreased dealer liquidity, particularly in spread and credit products. Much has been written on this topic as investors, financial columnists and regulators express concern regarding potential illiquidity in volatile markets. For now, this week’s lull in volatility has been beneficial for spread and credit products: premium TBAs outperformed their Treasury hedges by between 3 and 9 ticks while IOS indices tightened between 30 and 40 basis points of OAS. Despite the “risk on” mentality, we maintain a cautious view as potential headwinds may arise.

Given our viewpoints, we thought we would use this week’s commentary to examine the costs of hedging an IO as we might do in the portfolio. Going long a position in IOS FN-2003 5.5% carries at 1.5 ticks a month. Adding FN 4.5 TBA to hedge the mortgage rate and neutralize duration exposure adds 8 ticks. To offset additional curve risk we might use interest rate swaps and/or US Treasuries, costing 1 tick. And given our view on volatility, we might utilize straddles to hedge gamma and vega, consuming 2 ticks. The net result is 6.5 ticks of carry.[1]

The above illustration shows that hedging activities can have a material impact on strategies that include carry as a source of returns. Some risks may be worth hedging, while others may not be depending on your market views. Of course, the best hedge is to have no position on at all, but the opportunity cost is great.

Happy hedging,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

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[1]  Calculations and table produced using Credit Suisse’s Locus platform

FLASH UPDATE: TRV Weekly Commentary

TRV Weekly Commentary
Week Ending 21 Oct 2014

Comment:

Following last week’s dramatic risk-off sentiment and increase in volatility, we saw a moderate retracement as the 10yr sold off 9bps and implied volatility decreased 22bps. The basis performed well as investors cautiously added risk. The stack added 5-7 tics versus its 5 and 10yr hedges, as the curve moved in a parallel fashion. Despite the tightening, we remain bearish on the basis as we foresee increased volatility in the coming months. Additionally, we have seen average daily supply increase for three consecutive weeks to $2.7 bln, which is also a concern for the basis.

Primary rates hit 2014’s low on October15^th as the national average 30-year fixed mortgage rate fell below 4% to 3.93. The significant decrease in primary rates led to a 23% increase in the refi index, sparking fear of increased refi activity. Investors especially penalized slight premium benchmark IOs, demanding greater OASs for the perceived risk. FN30.350.10 widened 51 basis points this week, while FN30.400.10 widened 39 basis points. We anticipate spread widening for 3.5 IOs as refi optionality comes into the money on lower rates and increased vol. A 4/3.5 IOS swap may be a trade to watch to capture further spread widening in 3.5s.

Over the last two weeks, we saw spec pool payups on premium 3.5s increase, particularly on medium and low loan balance stories. Notably, payups increased 7+ and 6+ ticks for LLB 3.5s and MLB 3.5s, respectively. Also of note is the increase in the price of prepay protection for CR 4s as payups increased 10 ticks during the same period.[1]

Lastly, the FHFA outlined a plan to refine the Rep and Warranty Framework and provide clarity as to when the GSEs would exercise their remedy to require loan repurchase. The FHFA hopes that the plan will lead to lower perceived risk to originators allowing them to write loans more freely. The announcement caused little market action as it is expected to have a marginal impact.

Noteworthy:

In this week’s noteworthy section, we examine whether the payup on FNMA 4 LLB and MLB prices prepayment risk fairly. To analyze the price of prepayment protection, we used the FNMA 4 November TBA price as of 10/21 to calculate its OAS to swaps. We then priced LLB and MLB FNMA 4s of 2010 using the TBA OAS. We found that actual payups were more than one point cheap according to our prepayment and OAS model. We thus expect payups to increase as refi risk comes to investors’ attention.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

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[1] LLB and MLB collateral describes low loan balance and medium loan balance collateral. These collateral types typically offer prepayment protection as the dollar incentive to refinance is lower with lower mortgage balances.

CR collateral is 30yr collateral composed entirely of mortgages with LTVs greater than 125. High LTV implies prepayment protection due to perceived difficulty to refinance.

FLASH UPDATE: Vulnerable High Yield Bonds Fall in Price Prior to Spike in Defaults

After speaking to many investors over the last year about the opportunity of being short high yield bonds of vulnerable and challenged companies, I think the most common misconception is that there is nothing to do until default rates spike.  Many market prognosticators are calling for significant spikes in the US corporate high yield default rate, starting in 2016 and likely sustaining to 2018-2020.  Does that mean that we should try to time being short closer to 2016?  The answer is unequivocally no…Once default rates start to spike, the short trade is most likely near its end and one should be thinking about buying asymmetrically priced, defaulted or distressed bonds where you have multiples of upside available. 

As an example, during 2007 and 2008 the annual default rate was below 2% every month with the exception of December 2008.  December 2008’s final default rate number didn’t come out until mid-January 2009.  Had you waited for a spike in rates in order to start putting short high yield bond trades on, you would have had about the worst timing possible as markets essentially went on an unabated six year run straight up starting in March 2009. 

With special thanks to Dr. Altman, Brenda Kuehne and the rest of the NYU research team for data, please see the below chart which shows the quarterly default rate, the 12-month moving average default rate and the index of defaulted debt securities.  You can simply see that every period of persistently low default rates is followed by extended periods of negative price performance in the index.  Every period of extraordinarily high spikes in the default rate is immediately followed by strong positive price performance in the index.  Extended periods of low default rates are a LEADING INDICATOR OF SPIKES IN DEFAULT RATES.

We think that the time is now to be short of the most vulnerable and challenged high yield corporate bonds.  Most of these companies have been consistent underperformers over the better part of the last decade, have cyclical or secular headwinds, are in serious danger of default or restructuring and are strangely trading at prices at or above par.  Take advantage of the asymmetry available today and the fact that we have had 15 consecutive quarters of annualized defaults below 2.2%. 

Happy Columbus Day, as Italians we don’t get very many holidays!

Richard Travia

Portfolio Manager, Director of Research

FLASH UPDATE: TRV Weekly Commentary

TRV Weekly Commentary
Week Ending 07 Oct 2014

Comment:

The yield curve slope was unchanged as both 5 and 10yr yields fell 5 basis points. The 10yr, currently at 2.39, continues its rally from its mid-September peak given reduced global growth projections from the IMF and the Fed. Volatility continues to increase as market participants expect the Fed to end its MBS purchase program this month. Despite an imminent end to Fed tapering, mortgages kept pace in the rally as performance surpassed that of benchmark Treasuries. Discount coupon performance was 2 ticks better than par and premium coupons this week due discounts having higher spread duration.

The refi index closed up 61 points (5%) as 30yr fixed rate mortgages fell 3 basis points to 4.30. We saw refis as a percentage of loan applications rise to 56.4 percent into the rally. OASs on premium and cuspy IO benchmarks (4s of 10-13 and 4.5s of 10 and 11) increased between 2 and 5 basis points on what investors perceived as a slight uptick in prepayment risk. It may be worthwhile to watch for widening in these benchmark bonds if rates continue to rally. Oppositely, benchmark 3.5 IOs of 10-13 tightened between 7 and 8 basis points as investors continue to reach for yield. IIOs had a great run in September, grinding between 50 and 100 basis points tighter given lower supply, slower seasonals, and a low refi index. Although at local tights, a few dealers justify the current IIO clearing levels.

Spec pool payups were relatively flat despite the rally. The lull in price action precedes prepayment day when September factors are released. Generally, September prints generally came in line with expectations while par and premium speeds came in faster than anticipated. Spec pool payups continue to be cheap compared to their theoretical payups when priced to TBA OAS. Using this analysis, 30yr 5s appear the richest, as loan balance and FICO payups are between 60 and 70% of their theoretical prices.

Noteworthy:

Given this week’s lunar eclipse (and ensuing moon selfies), we thought it would be appropriate to share a fun fact about our celestial neighbor. The moon’s orbit has increased from 14,000 miles to 280,000 miles since formation as it steals a fraction of Earth’s rotational energy.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

Jeff Kong featured in Opalesque - New Fund Launch

Benedicte Gravrand, Opalesque Geneva:

Tradex Global Advisors is concocting an all-weather absolute return strategy that aims to exploit the inefficiencies within the mortgage-backed securities (MBS) market. It will be run by Jeff Kong, who used to manage Passport Capital’s M1 Fund and SPM’s mortgage fund.

Jeff Kong joined Tradex Global Advisors LLC, an alternative asset management company based in Greenwich, CT, as a partner and portfolio manager responsible for all mortgage-related strategies, in July.

"Looking forward, we certainly expect the fixed income investing landscape to change dramatically as central banks alter course and the rules change. Success in this arena requires a talented and seasoned portfolio manager as well as an equally skilled organization. I believe that with Jeff at the helm, our business has both," then said Michael Beattie, one of the firm's founding partners and its Chief Investment Officer.

Prior to joining Tradex, Mr. Kong was a portfolio manager at Passport Capital, which he joined in 2010 to run the M1 Fund(which returned 13% in 2012). During the previous 10 years, Kong managed the approximately $1bn flagship SPM mortgage fund (the Structured Servicing Holdings or SSH) at Structured Portfolio Management; that fund annualized at +23.6% during his tenure. Prior to that, Mr. Kong served as a director at Donaldson, Lufkin & Jenrette for whom he was a market-maker in mortgage-backed securities, and a vice president at Greenwich Capital Markets.

"I have partnered with Tradex to launch a fund not unlike what I’ve managed in the past, both at SPM and at Passport," he told Opalesque. "Joining forces with Tradex was an easy decision since we have been in business together for over 10 years, as Michael and Richard were early investors in SSH. Our team is currently finalizing documents for our business relationships and service providers, and we are looking to launch the Tradex Relative Value (TRV) fund by Jan 1, 2015."

According to Mr. Kong, TRV is an all-weather absolute return strategy that aims to exploit the inefficiencies within the mortgage-backed securities market.

TRV’ strategy employs the arbitrage of implied versus delivered fundamentals to extract alpha. Because the performance of mortgage-backed securities is dependent on the understanding of the imperfect and changing behavior of borrowers, the team’s experience across numerous market cycles is advantageous, Mr. Kong says. The TRV platform enables them to provide excess returns for their investors throughout various interest rate and economic cycles.

The goal is twofold: to target a high level of positive carry in the fund and to capitalize on market dislocations that frequently present themselves during times of change or stress, as has occurred many times during Mr. Kong’s career.

"In fact," he adds, "the current economic landscape could likely lead to the type of market disruptions and volatility that present significant opportunity to the TRV strategy: the Fed’s exit from quantitative easing, the end of generationally low rates, and the questionable role of the Agencies in housing finance are examples of catalysts to market dislocation. With our infrastructure and team, we are excited to launch TRV into what we see as a period of uncertainly and therefore opportunity."

Background
An MBS is a type of asset-backed security that is secured by a mortgage or collection of mortgages. They are traded actively, much like bonds. The majority of MBSs are issued and backed by government-sponsored corporations such as the Government National Mortgage Association (Ginnie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae). These securities provide safe income, and some capital appreciation as interest rates fall. Some investment banks, such as JP Morgan Chase, Citigroup and Credit Suisse, andMorgan Stanley, are being sued by investors claiming they were misled on the safety of MBS before the crisis, CalPERSbeing one of the alleged victims. But such securities are back in fashion among asset managers.

The Credit Suisse Fixed Income Arbitrage Hedge Fund index is up 3.89% YTD (to August) and returned 5.77% over the last 12 months. The HFRI Fixed Income-Asset Backed Index is up 7.1% YTD, 11.2% in the last 12 months.