FLASH UPDATE: 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.

Consistent Risk-Adjusted Return

Carry is the interest earned on our invested assets, and net carry is the interest earned after hedging costs. 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, are accretive to carry and can provide investors with a predictable source of income while minimizing interest rate exposure.

Why Now?

We are at a pivotal point for our core prepayment arbitrage strategy. The approach, which targets interest payments from home loans, is agnostic as to whether interest rates rise, fall or stay the same due to our unique, market-neutral hedged strategy. 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. In this environment, credit-oriented strategies have more default risk and would be vulnerable to losses, whereas prepay-sensitive assets would likely benefit from more interest income. Alternatively, if rates rise, our cash flow and carry would also rise and our hedges would protect against the convexity. As homeowners lose their incentive to refinance, our proprietary models would be in a superior position to pick the most attractive securities in an environment of slower prepayments.

An experienced manager should be able to spot mispriced securities and capitalize on the present confusion among market participants. These market conditions present an extremely convex profile that no other asset class provides, making this such an opportune time for our strategy. Furthermore, these securities have become cheaper in recent weeks, with Agency IOs trading at close to two-year wides.

Summary

Surveying the landscape of fixed-income alternatives, to achieve comparable carry to prepayment arbitrage strategies, investors have to extend duration or take on undue credit risk. Hungry for yield, investors were quick to gobble up debt issued by high-yield (junk) companies, many of which were already over-leveraged and on the verge of insolvency. As the cracks turn to deeper divides in corporate credit, Agency IOs will benefit from stronger fundamentals and may exhibit less volatility. A solid understanding based on in-depth modelling of homeowner behavior, will allow astute investors to implement prepayment arbitrage strategies that can outperform regardless of the effect of global-macro conditions on forward interest rate paths.

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

FLASH UPDATE: Sources of Alpha in a Multi-Strategy MBS Portfolio

Overview

Given increases 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. During the strong bull market from 2009 to 2014, beta exposure was often misclassified as alpha generating 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.

Alpha, the most 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. 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 mortgage portfolio.

Prepayment Arbitrage

Prepayment arbitrage, as a fixed-income arbitrage strategy, offers skillful managers a variety of ways to capture alpha in mortgage backed securities (MBS) while hedging out exposure to interest rates (beta). Proprietary models aid mortgage investors in identifying opportunities when a security is cheap, relative to its intrinsic value, 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 MBS 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

Relative value trading strategies in Agency MBS pass-throughs can provide a pure alpha stream. 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 MBS, there are unremitting moments of detachment that can be capitalized upon in tactical, duration-neutral trades. These include the Agency mortgage basis (versus Treasuries or swaps), or pair trades in Agency MBS 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.

Opportunistic Credit

Investing opportunistically in Non-Agency mortgage credit allows for a source of alpha, through the disproportionate upside offered at moments of technical dislocations, that result in the mis-pricing 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.

Summary

Multi-strategy mortgage 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. 

We encourage readers interested in learning more about capturing alpha through a mortgage strategies to contact the investment team at Tradex for further discussion.

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

Tradex Global Short-Biased High Yield Fund Ranked #2 Fixed Income - HY Fund in August by BarclayHedge

In August, the Tradex Global Short-Biased High Yield Fund was ranked for the 3rd month in a row by BarclayHedge, this time appearing as the #2 "Fixed Income - High Yield" Fund.  Please see the below award:

Hedge fund performance as ranked by the BarclayHedge's database

FLASH UPDATE: Anatomy of a Market-Neutral Mortgage Strategy

Market-neutral strategies profit from identifying and exploiting mispriced securities while eliminating the impact from market movements.  In this piece, we provide a straightforward overview of a market-neutral approach within a mortgage strategy. If markets were completely efficient, then a fully hedged portfolio would earn the risk-free return. It would be irrational for a manager to go through the process of strategy building and portfolio management when simply purchasing T-Bills would produce the same outcome. In reality, market inefficiencies do exist and the most skilled managers capitalize on them to generate a persistent stream of positive risk-adjusted returns by prudently taking calculated risks. In general, the goal of a fixed-income arbitrage strategy is to hedge out the unwanted (market) risks while generating returns through exploiting pricing inefficiencies (sector/security).  In a mortgage strategy, the most persistent source of return is hedge-adjusted carry - income earned net of hedging costs.  Other sources include statistical arbitrage and opportunistic purchases of fundamentally undervalued securities.

Interest Rate Risk

The primary driver of returns in a fixed-income security is its duration, or interest rate sensitivity.  This is the foremost source of market risk, and successful market-neutral strategies buffer the portfolio against it by implementing a hedging strategy to maintain a near-zero duration with minimal yield curve exposure. An optimal mix of hedges (cost and efficacy) are selected to offset the partial durations of the portfolio’s core investments.  Treasury and Euro Dollar futures and options are commonly used to hedge duration.

Spread Risk

Movements in spreads (risk premia) also affect the valuation of fixed income securities, and sensitivity to this risk factor is measured by spread duration. Risk premia can increase for a variety of reasons. Some of the main drivers include expectations of weakening market fundamentals, the ensuing effects of an increase in volatility, and intermittent technical factors causing a glut of supply.  Spread risk can be offset using a variety of hedging instruments.  Swaps and swaptions are effective hedges against interest rate volatility and broad market moves in risk premiums, while mortgage securities and the mortgage basis can be used to offset phenomenon that are more local to the mortgage market. Value-at-risk (VaR), an industry standard risk metric, can be used to measure spread risk using historical spread volatility for the types of securities held in a portfolio and to manage the exposure to be within an acceptable bound (e.g. 2%).  By managing this risk within a range, the strategy accomplishes two things: 1) the ability to generate hedge-adjusted carry is not impaired from over-hedging and 2) as deemed necessary, the resulting savings can be used for tail hedges to further protect against systemic risk.

Risk Adjusted Returns

Tradex delivers a market-neutral product in its multi-strategy mortgage portfolio with the aim of providing investors with an all-weather investment resource that generates persistent alpha through a return series that exhibits reduced volatility and low correlations to traditional and alternative investments. 

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

Remembering September 11th

To all of our friends and business partners,

Tradex wants to remember the victims and those affected by the September 11^th tragedy and have decided to donate a portion of our September fees to Tuesday’s Children, a charity that promotes long-term healing for those directly impacted by the tragic 9/11 event.  Tuesday’s Children provides programs such as career counseling, youth mentoring, mental health & wellness, widow support programs, life management skills, among others.  We encourage you to make a donation to this worthy cause for those in need.  Please click here to make a donation now:  http://www.tuesdayschildren.org/donate/#.VfHk5BHBwXA

Best regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: Versatility of CMBS

Summary

CMBX indices are widely referenced market instruments among structured credit investments.  Yet, we find that a large portion of investors are operating on partial information in regards to the various uses of CMBX and the potential benefit from active management.

Definition of CMBX

Each CMBX index is a basket of credit default swaps (CDS) on a static basket of CMBS and provides investors with a means of obtaining diversified exposure to specific rating categories within the reference pool. A majority of the 20 primary dealers make active markets in CMBX, making the indices liquid and accessible. The transparency of widely quoted markets and bid/ask spreads that are narrower than bonds in the cash market provide investors with an efficient and versatile tool for expressing varying views in CMBS. 

Mechanics of CMBX

CMBX contracts are structured to closely follow the cash flow of the underlying deals, according to Internal Swaps and Derivatives (ISDA) “pay-as-you-go” (PAUG). In this CDS format, the buyer and seller make two-way payments over the life of a contract.  The performance of the contracts is structured to provide investors with a means of expressing a positive or negative view on the basket of bonds in the basket of reference securities.

CMBX buyers “sell protection” by taking on risk associated with the CMBS portfolio and profit when the reference pool performs better than the implied performance at the time of purchase.  In essence, they are exhibiting a bullish view.

CMBX sellers “buy protection”, and pay an upfront fee and fixed premium to index buyers in exchange for payments to cover losses in the event of any writedowns or shortfalls.  They are either aiming to hedge or express a bearish view.

Source:  CMBX The Long and Short of It, CRE Finance Council 2014

Hedging

CMBX can be used to hedge a portfolio against credit exposure as well as systemic market movements.  Credit risk on a portfolio can be mitigated through taking a short position in a tranche with similar characteristics as the portfolio.  However, basis risk increases over time as the credit performance of the specific securities referenced by the CMBX and those held in the portfolio drive the respective outcomes.  To hedge market risk, newly issued series are an effective tool given their high correlation to market indices like the S&P 500.  The correlation is driven by ease of access and low capital commitment, allowing investors to quickly and efficiently express a risk-off view to protect against a systemic sell-off in credit markets.  The chart below illustrates the relationship between the S&P 500 and the A tranche of the CMBX.6 series (CMBX.6.A).  It demonstrates how tactical short positioning as sentiment shifts provides a means to cushion the downside.

During major market drawdowns, there are opportunities for hedging by shorting CMBX.

Directional

With the observed relationship between a benchmark index like the S&P 500 and certain CMBX indices, it is logical that there would also be opportunities to profit from directional moves in broad markets on major shifts in sentiment.  Investors can go long or short in CMBX accordingly to reflect their expectations for market performance.  As an example, taking a view based on a technical indicator like the RSI to gauge the potential for a directional move in the broader market, one can implement a CMBX strategy with the aim of profiting from near term shifts in sentiment.  Examples of such moments are annotated in the graph.  

In the rebound period following major market corrections, there are opportunities for directional long trades.

Relative Value

CMBX can also be traded using a relative value strategy, where opportunities arise from dislocations in the pricing of different tranches within a given series. As an example, we developed and tested the effectiveness of a multilinear regression model to predict CMBX.6.AA. We chose CMBX.6.A and CMBX.6.AAA as our explanatory variables.  As shown in the chart, relationships between highly correlated tranches can be modeled and used to signal relative value trades.  Statistically significant dislocations serve as potential opportunities.

Conclusion

CMBX is a multi-faceted tool that provides investors with efficient means for achieving a range of objectives. Those well versed with this product can utilize it in the active management of a portfolio to add incremental returns across a dimension of market environments. It is a useful tool for opportunistic investors to include in their alpha sources.

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 #3 Fixed Income - HY Fund in July by BarclayHedge

In July, the Tradex Global Short-Biased High Yield Fund was ranked for the 2nd month in a row by BarclayHedge, this time appearing as the #3 "Fixed Income - High Yield" Fund.  Please see the below award:

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