FLASH UPDATE: $50 oil is worse for consumers than you think

The price of crude oil has fallen approximately 55% since June.  At the same time production is hitting all time highs...Supply and demand tells us that we could be setting up for more downside in the energy complex.  For many reasons, overall rig count is down 15% since October 2014, matching the lowest levels since October 2010.  The Bakken Shale and Permian Basin, where horizontal drilling has been the primary method used in the tight rock formations, have seen significant shut downs.

Producers have already guided that spending in the US & Canada will be 30-35% less than last year. Internationally, Qatar Petroleum & Royal Dutch Shell canceled plans for a $6.5 B petrochemical plant, due to the JV becoming "commercially unfeasible" in the current energy market.  This is after Qatar announced a $6 B project cancellation in September as well.  Statoil ASA also announced a delay in an offshore drilling project.  Cost cutting and delaying investment has already started selectively.  Something has got to give soon...

Schlumberger just announced that they cut 9,000 jobs at the year end.  They took $1 B in charges in Q4, $300 mm of which directly related to downsizing staff.  Separately, three contract drillers that we are aware of recently had clients terminate rig contracts early.  One of them layed off 700 employees unexpectedly.  A senior economist at the Dallas Fed said that Texas could lose 140,000 jobs if crude stayed below 50% of the 2014 average.

The Perryman Group estimated that the energy industry generates $1.2 T in gross product annually, as well as providing 9.3 mm permanent jobs.  Since Dec 2007, 1.36 mm jobs have been gained in shale oil states vs -424 k in non-shale oil states.  Please read that last sentence again.  This is much worse for the consumer than you may think.  The consumer is already on weak ground, and a major loss of jobs & confidence could be a death blow.

Depending on the index, ETF or mutual fund, energy makes up 15-25% of high yield exposure. Marty Fridson calculated that 18.1% of high yield energy issues are already trading at distressed levels (vs 8.45% overall and 4.16% overall excluding energy).  This pain in the energy sector of the high yield market could be the catalyst we have been waiting for to set things off.  I have no doubt that if crude remains low, this will be a major blow for the economy and the consumer.  We are excited that we've been able to add to positions above par while "all is well" outside of energy.

We are back!  Enjoy the long weekend and Happy New Year to everyone.  Please reach out to investorrelations@thetradexgroup.com to receive an invitation for our next webinar on "The State of the HY Market", presented by our Senior Advisor, Dr. Edward Altman

Best regards,

Richard Travia
Director of Research.

FLASH UPDATE: TRV Weekly Commentary - Opportunity in IOs

TRV Weekly Commentary
Week Ending 17 Dec 2014

Comment:

This week was an active week in trading, particularly in commodities, rates and MBS derivatives on market turmoil. Below are some highlights that have contributed to the increase in vol this week:

• WTI crude futures reached an intraday low below $55/barrel on the Tuesday (see graph)
• The Russian ruble depreciated to a high of $79.16 USD from $64.23 USD (see graph)
• The Swiss National Bank imposed a negative 4.6 bps deposit rate on Thursday
• The FOMC meeting minutes reflect a close monitoring of inflation and the “transitory effects of lower energy prices” on Wednesday
• The 10/5 spread compressed 8 bps
• The 10yr reached an overnight low of 2.01 on Tuesday

Implied vol on 10yr swaps increased 3 ticks on these data points and we saw equities, spread and credit products sell-off. The market turmoil largely began due to lower energy prices, causing the Russian Ruble to depreciate substantially. From there, a domino effect insured with the S&P500 selling off 2.64%, the mortgage basis underperforming by 4 to 9 ticks versus 10yr hedges, and IOs cheapening between 10 and 64bps of OAS.

In IOs, we argue that it may be an opportune time to be in the market as the underlying fundamentals are intact and refi risk is contained. A meager drop in mortgage rates and an unchanged refi index support this thesis. We see the best opportunity in 3.5s of ’13 as the IO benchmark widened 64 bps this week. Another potential opportunity lies in RMBS as 60+ delinquencies are generally declining, LTVs have been improving, and dealers have inventory in their balance sheets that can be cleaned up before year-end. We have seen some paper with strong credit support and stable cash flow selling for LM70s that may be sourced cheaply.

As we prepare to launch in the next couple of weeks, we look forward to future market dislocations that will provide opportunities in our markets.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

Russian Ruble vs WTI crude futures

Contagion! Is that still a word?

Liquidity in the lower rated junk bonds has already started to become tentative at best.  Over the last few months, volatility has risen significantly and a true reassessment of risk has begun with investors.  Bid-ask has been gappy and inconsistent, both on the downside and upside.   It has been fairly obvious for a long time that investors are not being compensated properly for the risk that they are taking on in the high yield market, particularly in the CCC-rated sector.  As pain from the energy sector spills over into the rest of the high yield market, and illiquidity becomes a reality, investors may soon be met with a reminder about what the word “contagion” means. 

HYG & JNK are trading at 2 year lows, and retail investors who blindly own high yield for the “safety of fixed income” are likely scratching their heads, as they wonder why and how their investment can lose in price.  They probably thought that it was just a safe yield that they could bank on.  30% of high yield ETF holders are hedge funds, and they will move the needle quickly when trying to avoid any losses from a headline risk type of trade, such as being long high yield.  Outflows have not started yet in these two ETFs, but if the past is any indicator, outflows will be large and fast.  July 2014 saw $12.6 B of overall high yield outflows; the impending problem could make July pale in comparison. 

As contagion takes hold, the illiquidity will likely become an exponential problem, as liquid equity ETF structures and daily dealing mutual funds struggle to create underlying bond liquidity, especially at a NAV that doesn’t represent significant gaps.  Once those gaps start to become apparent, trust is quickly lost in the structure itself.  NASDAQ released a white paper earlier this year, citing liquidity as the #1 ETF myth that could lead to investor losses. Lower rated high yield paper is starting to roll over…how will you be positioned? 

Enjoy the football today,

Richard Travia

Director of Research

FLASH UPDATE: TRV Weekly Commentary - Rate & Refi Volatility

TRV Weekly Commentary
Week Ending 19 Nov 2014

Comment:

The 10/5 spread compressed to 71 bps this week as rates bull-flattened. We attribute half of the 6 bps decline to Japan’s poor 3Q GDP print. On an annualized basis, Japan’s economy contracted 1.6%, a stark contrast to expectations, a 2.2% expansion. This data point shocked Japanese equities, with the Nikkei falling 3% . The US bond market reaction was more muted, although implied swaption vol ticked up 2 bps. We do anticipate that the unexpected contraction of the third largest economy will have had a meaningful impact on US output.

Assuming Japan’s recession has a material impact on US growth, we would expect rates to rally and spread products, such as mortgages, to lag. For now, the basis continues to outperform its Tsy hedges as down-in-coupon MBS outperformed the 5yr by 8-10 ticks. We retain a neutral to bearish view on the basis as the yield spread between the current coupon and the 5yr is 1.89 standard deviations below its mean, origination remains strong, and the Fed has finished growing its balance sheet.[1]

Notwithstanding the fall in Treasury and primary mortgage rates, the refi index fell 17 points. While this seems counterintuitive, consider that the average 30-year mortgage rate reached a low of 3.93 only one month ago. Two important mortgage concepts come into play, seasonality and the refi ‘elbow’:

§  Seasonality has a large impact on turnover in the housing market. The housing market, in terms of existing home sales, tends to pick up in the spring, reach its peak in the summer, and decline through the winter as shown in the Prepayment Seasonality chart. When a homeowner sells a house, the existing mortgage principal is paid off in full upfront, just as it happens in the case of a homeowner refinancing his loan. As we enter the winter months, prepayments will likely decrease absent a large movement in rates or a new government program.

§  The refi elbow, on the other hand, refers to the homeowner’s incentive to refi at prevailing rates. If the rate incentive were only 5 bps, we would expect minimal refi activity. However, if the rate incentive increased to 25 bps, we would expect refi activity to pick up. The Refi Elbow chart illustrates the impact of shifting the ‘elbow’ 50 basis points, thus adding 50 basis points to refi incentive. As incentive increases, we see the one-year CPR for a FNMA 3.5 TBA increase. The term ‘elbow’ comes from the shape of the curve, which loosely resembles an elbow.

Considering these concepts, it's no surprise that the refi index fell this week: seasonal impacts likely overcame the minimal shift in rates. We hope this illustration informs the reader of a portion of the anatomy of prepayments.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

Prepayment Seasonality

Refi Elbow

Mortgage Basis Data

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[1] We estimate the basis as the difference between the price of Bloomberg’s MTGEFNCL Index and the yield of a generic 5yr Treasury. The data show daily spread levels between 11/21/2007 and 11/19/2014. See the chart at the end of this document for more information.

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