FLASH UPDATE: Porfiting from the impending decline in Fed's Agency MBS Buying

As Treasuries begin to refocus on the Fed’s initiation of policy tightening, it is prudent to also consider the effects of the inevitable deceleration in its MBS reinvestment program.  While the Fed has already stopped its QE3 purchases of $40 billion per month in AGY MBS, they are still currently reinvesting principal and interest payments from their MBS portfolio into new securities.  The reinvestment program results in $20 to $30 billion in monthly MBS purchases.  While our expectation is that the Fed will not liquidate their portfolio of AGY MBS, we expect them to transition towards run-off mode by ceasing to reinvest payments of principal and interest.

Shorting the basis is one of the trades we are eyeing as part of our AGY MBS relative value trading strategy.  We anticipate that over time the basis will revert towards pre-crisis levels as the Fed, who is currently by far the largest single buyer of MBS, exits the market as part of a reduction in quantitative easing.  Our view is that the Fed’s exit is not yet priced in and we examine an opportunity to earn outsized returns using a tactical short that will benefit from a retracement. 

At present, the AGY MBS basis sits near historically tight levels due to the influence of many supportive factors (Fed purchases, limited available float, low rate volatility, tight credit conditions/benign issuance). These factors are reversing course and will push the basis wider.  While higher regulatory hurdles have impeded loan origination over the last few years, rising interest rates will begin to serve as an incentive for banks to increase their lending activities.  The combination of increasing supply, reduced Fed buying, and rising volatility should put pressure on mortgage spreads.     

The spread between AGY MBS and Treasuries, which currently sits near 75bps, is markedly tighter than its pre-crisis average of 125bps. The chart below illustrates the trade’s expected return assuming the spread retraces 50% of the gap.  For perspective, this 25 basis point move would be smaller in magnitude and could occur in a like timeframe as the 35bp widening experienced over a six-week period during the summer 2013 taper tantrum. 

Please contact us if you would like to hear more about our view on this trade thesis or our other thematic ideas.

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

Tradex Global Short-Biased High Yield Fund Ranked #1 Fixed Income - HY Fund in June by BarclayHedge

This fund was ranked based on the data in Barclay Hedge's hedge fund database

FLASH UPDATE: Winter is coming. Keep returns warm in a rising rate environment

Given the imminence of a rate normalization cycle, many investors are preoccupied with the notion that traditional fixed income investments, such as Treasuries, will lose value as rates increase. Such assets will likely decline in value as the coupons of the securities will be below market coupons. In fixed income, we refer to this concept as positive duration. As such, many investors have shied away from an asset class that is abundant with opportunity. An astute investor may short traditional fixed income securities to generate positive return as rates rise. While such a strategy should benefit from a rising rate environment, there is a limit to the benefit as the cash flows of traditional fixed income assets are fixed. Moreover, this strategy has negative carry due to owing coupon income and the cost of borrowing. We have found that certain classes of Mortgage-Backed-Securities, such as Interest Only Securities, often offer the most attractive return in a rising rate environment as their valuations rise and expected cash flows increase.

The chart above shows the theoretical total return – price appreciation and net carry – of the aforementioned strategies, assuming the yield curve follows the Fed’s ‘Dot Plot’ in a linear fashion through December 2017. For simplicity, we assumed spreads on the IO securities remain constant. While the short Treasury position appears attractive, the returns are dwarfed by those of the IO due to the increase in cash flow earned over the life of the IO. Given the imminence of rising rates, we feel this is an opportune time to invest in IO securities as they offer attractive carry and are expected to increase in value in rising rate environments.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: Normalization of Non-Agency RMBS

It all starts at the ground level – or more specifically at the underlying asset.  The housing crash and recovery led to write-downs and then opportunities for investors in Non AGY MBS.  Now, as this article demonstrates, the opportunity in housing is normalizing, and so too will the returns of instruments tied to the recovery (notwithstanding a handful of niche sectors).  On the plus side, stabilization of the housing market and shifting paradigms in homeownership are opening the door for an increase in loan origination and new asset classes like single-family rental securitizations.  We are moving into a new era for residential mortgage credit investing where opportunism, research, and breadth of experience will preside over credit beta.

Home Investment Market Shifting with Fewer Foreclosures

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: How Will the Newbies React to the Coming Change in Interest Rates?

People tend to have short memories and that can become problematic when it comes to investing.  Having no recollection at all can be even worse.  Wall Street’s newcomers have benefited from an extremely accommodative introduction to their careers and the resulting false bravado will likely lead them to underestimate the pitfalls that arise in during tightening cycles.  Investors should choose carefully when seeking advice and allocating their capital.  If we ignore history we are doomed to repeat it.

See the below link for an interesting Bloomberg article and clip:

What Will Happen to a Generation of Wall Street Traders Who Have Never Seen a Rate Hike?

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: TRV Mid-Month Commentary - Rates on the Move!

TRV Mid-Month Commentary | May 2015

Policy Update:

Before we provide an update on our markets, we would like to outline an important FHFA proposal that, if passed, will have significant impact on the markets in which we trade. On May 15, the FHFA released an update on the structure of the Single Security in accordance with the goals set out in the 2014 Strategic Plan for the Conservatorships of Fannie Mae and Freddie Mac. The main goals of the Single Security are to build a Common Securitization Platform that adds market liquidity and reduces or eliminates taxpayer costs of Freddie Mac securitizations.

Freddie Mac securities traditionally trade at a discount to comparable Fannie Mae due to reduced liquidity. If the proposal is passed, we expect Fannie Mae and Freddie Mac securities to trade close to parity during and after the transition. Overall, we believe the proposal will increase market liquidity and reduce taxpayer costs as mentioned by the FHFA.

Comment:

Despite the disappointing revision to March’s Change in Nonfarm Payrolls, Treasuries sold off dramatically in the first half of the month. 10yr yields ended 26 bps higher and the curve steepened 12 bps 5s/10s. We expect IOs to perform well in a higher and steeper yield curve environment. Likewise, we would expect CMBS and residential credit to generally increase in valuation as buyers seek yield.

One impact on valuations would be an increase in delivered and implied volatility. Over the past two weeks, swaption volatility increased 13 bps (1 month into 10 year). Since our portfolio is tactical in nature, we stand to benefit from dramatic market changes that lead to mispriced assets. Pass-throughs may present such an opportunity as prices dramatically lagged those of Treasuries. We thus see an opportunity to be long the mortgage basis given recent underperformance and the likelihood that Treasury yields will remain range bound until further direction from the Fed. Decreased prepayment risk should provide further tailwind to the pass-through market and provide opportunity for spread compression.

In April, 30yr and 15yr conventional mortgage speeds declined beyond the street’s expectations. The key surprise for many investors was a larger than expected slowdown in new vintage collateral. This may signify that the street prepayment models are mis-calibrated to refi-sensitivity and, in our view, the market is under-valuing many prepay-sensitive bonds. As such, we have seen IO valuations rally and we continue to also look at other asset classes for opportunity.

                                                                                                         

Spread products, such as CMBS and residential credit, may be such asset classes with foreseeable spread compression as higher rates often indicate an improving economy. Commercial property fundamentals remain strong and we expect the trend to continue. In residential credit, we see limited upside to legacy positions, except in specific niche sectors. But at the same time we do not anticipate major spread widening in the near term as housing fundamentals and market technicals remain strong and supportive of the sector. Of note, we see value in Credit Risk Transfer (CRT) deals and point to wider spreads vs legacy RMBS particularly during market pull-backs.

While valuations on securities that stand to benefit from slower prepayments continue to grind higher, we are positioning ourselves to be opportunistic. We expect rates to end May higher as the market anticipates the pending Fed activity. However, we foresee near-term volatility remaining elevated given the uncertain nature of the forward rate path. As we mentioned, our strategy should benefit from such volatility as it will create openings for our tactical approach.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: Jeffrey Gundlach's History Lesson on the Fed & High Yield Bonds - Warning!

Jeffrey Gundlach, Warren Buffett, Bill Ackman & Carl Icahn all can agree on one thing...They don't want to own any high yield bonds!  The short high yield strategy has been getting some great press lately, as the warning signs flash brighter and brighter.  

“The risk is there could be a run on the bond funds, causing further downward price movement. A lot of investors don’t like Treasurys. They’ve been searching for yield and throwing caution to the wind,” said Jeffrey Gundlach.

“If I had an easy way, and a non-risk way, of shorting a whole lot of 20- or 30-year bonds, I’d do it,” Warren Buffett said Monday on CNBC. “...But I think that bonds are very overvalued, I’ll put it that way.”

“I don’t like fixed income as a category, particularly at today’s interest rates,” said Bill Ackman in a Bloomberg Television interview this week.

“What’s even more dangerous than the actual stock market is the high-yield market,” said Carl Icahn on this weekend's episode of the show “Wall Street Week".  Money keeps pouring into high-yield bond funds, even though that market is “ridiculously high,” Icahn said. “When they start coming down, there is going to be a great run to the exits,” he added. 

Gundlach, Buffet, Ackman & Icahn have joined Bill Gross, Stanley Drunkenmiller, George Soros, Ray Dalio & Jeremy Grantham in cautioning against overpriced and bubbly financial markets.  The bottom line is easy to see, some of the greatest investors of all-time are warning everyone...Don't own any high yield bonds!  Tradex is positioned to take advantage of this opportunity.  Click on the below link to watch Jeffrey Gundlach's recent high yield warning.  #ShortHY

Jeffrey Gundlach's High Yield Bond Warning

Richard Travia

Director of Research