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The Tradex Relative Value Blog Series Tradex Global Advisory Services, LLC


THE TRADEX RELATIVE VALUE BLOG SERIES PROVIDES AN IN-DEPTH DESCRIPTION OF STRUCTURED RATES ARBITRAGE AND OTHER OPPORTUNISTIC FIXED INCOME STRATEGIES IN THE CONTEXT OF CURRENT MARKET DYNAMICS.


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ur latest research series considers relative value fixed income investment strategies that are liquid, market neutral and


consistently produce alpha. We believe investors’ chief concerns include a changing U.S. interest rate policy, mitigating risks away from credit exposure, and maintaining liquid positions given the potential for increased volatility. In light of the current market environment as well as managerial constraints and goals, we outline a multi-strategy approach that touches on the above-mentioned environment and concerns.


SOURCES OF ALPHA IN A MULTI-STRATEGY FIXED-INCOME PORTFOLIO Overview Given the recent increase 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. Alpha, the most frequently 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. During the strong bull market lasting from 2009 to 2014, beta exposure was often misclassified as alpha in fixed income 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. 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. Capitalising 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 fixed-income portfolio.


Prepayment arbitrage of Agency structured bonds, as a fixed income arbitrage strategy, offers a variety of ways to capture alpha in structured products while hedging out exposure to interest rates (beta). Proprietary models aid US Government Agency investors in identifying opportunities when a security is cheap, relative to its intrinsic value. This is accomplished 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 fixed-income investors with differing objectives and constraints, those with superior models are presented with lasting opportunities to capture prepayment arbitrage. Purchasing cash flows that


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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 strategies in Agency pass- throughs can provide a pure alpha stream while investing in liquid securities. 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 bonds, there are unremitting moments of detachment that can be capitalised upon in tactical, duration-neutral trades. These include the Agency basis (versus Treasuries or swaps), or pair trades in Agency 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.


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


Multi-strategy fixed-income 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.


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.


Prepayment sensitive securities are unique in that what drives fundamental performance is the


behavior of individual homeowners. Every month, each homeowner faces the choice as to whether to continue to pay, to refinance, or default on their loan. This choice will be greatly influenced by such personal factors as household income, localised home prices, loan balance, and credit score, among others. These behaviors inevitably drive security cash flows, and thus performance of prepayment-sensitive securities.


While prepayment models have been developed to predict these behaviors, homeowners do not always act to maximise economic utility and so there are sources of model error. This is especially true for models that attempt to predict prepayments for large sectors of the market. Finely-tuned prepayment models are better equipped to project future cash flow and determine the relative rich or cheapness of a security. A manager that focuses on prepayment arbitrage must fully understand borrower behavior, market technical factors, and model projections.


A prepayment arbitrage strategy focuses on the market-implied behavior relative to the “delivered” behavior. To accomplish this, a manager must actively manage the portfolio with respect to prepayments to understand the sources of risk in prepayment-sensitive securities, and use liquid instruments to neutralise unwanted risks. The excess spread captured in a market-neutral prepayment arbitrage strategy can be thought of as pure alpha, as the returns generated typically exhibit minimal risk and a predictable source of carry. Another significant benefit of the prepayment arbitrage strategy is that the hedges are typically accretive to carry, which improves the already significant cash- on-cash yield.


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, can provide investors with a predictable source of income while minimising interest rate exposure.


Why Now? The approach, which targets interest payments from home loans, is agnostic as to whether interest rates rise, fall or stay the same given its hedged, market-neutral nature. 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. Alternatively, if rates rise, we expect carry would increase due to lower prepayment levels. As homeowners lose their incentive to refinance, superior prepayment modeling would be in a position to pick the most attractive securities in an environment of slower prepayments.


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