By Sam Diedrich
Associate Director, Pacific Alternative Asset Management Company (PAAMCO)
The European Central Bank's long-term refinancing operation (LTRO) has had a profound effect on risk assets and global financial markets during the first quarter of 2012. Prior to the liquidity provision, markets had been experiencing high volatility and correlations due to uncertainty regarding the burgeoning sovereign debt crisis in Europe and its possible contagion effects on global financial markets. However, with the provision in place, pressure on banks to reduce their balance sheets in Europe has been reduced (at least temporarily), risk aversion in global markets has been alleviated, and investors have shifted their focus back to economic fundamentals which, at least in the U.S., have been showing some improvement.
While this is good news, it has left many investors wondering where to invest today. The outlook in the U.S. has improved markedly in recent months, but equity prices have already appreciated substantially with the S&P 500 up over 10% in 1Q12. Though corporate default rates are low, they are unlikely to go much lower and the Credit Suisse High Yield Index has already returned 5% for 1Q12. Additionally, though economic figures out of the U.S. have been mostly positive, a weak March jobs number caught many by surprise. Meanwhile, though the LTRO provided much needed liquidity to the European banking system, long-term sovereign solvency questions remain and are likely to reassert themselves on investor risk appetite in the future. Thus, although fundamentals have improved, asset prices today appear to already reflect the improvements, which means potentially lower returns to investors going forward.
However, the non-agency mortgage market remains dislocated and is one segment of the fixed income market that continues to offer compelling risk-adjusted return potential despite the recent rally. Non-agency mortgages are attractive because of the high cash-on-cash yields available, the alpha potential due to the opaqueness of the market, the self-liquidating amortization feature of the bonds, and the opportunity to own high-yielding fixed income instruments with very low interest rate sensitivity.
Non-Agency Mortgages Offer High Yields Due to Distressed Pricing Levels
At issuance in 2007 and earlier, these bonds were rated investment grade and traded near par. At par, senior tranche bonds offered yields equivalent to their coupons which were generally around 5 to 6%. At par, these bonds were highly exposed to slight increases in mortgage default rates, severity rates, and even interest rates. In short, at par these offered low yield relative to the risk exposure.
Today, however, those same bonds trade at around 50 cents on the dollar, which alters the risk and return profile of the securities. The coupon of 4 to 6% effectively doubles when purchased at half of par value. At par, many senior bonds are vulnerable to losses when default rates are greater than 10 to 20%. However, now-discounted senior bonds are available at low double-digit yields even when incorporating lifetime default rates of the underlying mortgage pool of up to 75% or more into the valuation model. In fact, senior non-agency bonds are currently priced assuming further declines in home prices, further increases in default rates and further increases in severity rates, but still offer yields nearing double to that available in high yield corporate bonds. The reason these factors are modeled with such dire prospects is that those dire scenarios may in fact occur as the housing market is far from fully recovered. However, for many investors these risks are attractively priced and the yields are sufficiently high to warrant an allocation.
Another very attractive feature of non-agency mortgage bonds is that they are self-liquidating. In most credit instruments, such as high yield bonds or commercial mortgages, a coupon is paid periodically and a bullet principal payment is due at maturity. In order for the issuer to repay the loan, the issuer often must roll the debt, relying on prevailing financial markets to issue a new loan near the time of the debt maturity. In periods of extreme financial stress such as in 2008, the new issuance market for most types of credit can quickly evaporate, posing a large problem for any issuer hoping to roll their maturing debt obligations. However, residential mortgages are self-liquidating due to the amortization feature of the bonds, which receive both principal and interest payments every month. The non-agency mortgage market is currently about $1.1 trillion in size and receives approximately $100 billion in repayments each year.
Potential for Alpha Through Trading
In addition to the distressed prices of non-agency bonds being an attractive allocation from a cash flow yield perspective, the non-agency mortgage market is also an attractive allocation due to the potential for alpha through trading. The non-agency market is dislocated and opaque. Unlike equities or most other credit markets, there is no pricing transparency through an exchange or pricing service. There are tens of thousands of different CUSIPs in the market and complex models are required to value and evaluate each bond. Furthermore, in the new regulatory environment, investment banks have retreated from the market, leaving more opportunity for hedge funds to extract returns through trading.
Low Sensitivity to Interest Rates
Finally, non-agency bonds are attractive in today's record low interest rate environment due to their low sensitivity to interest rates. This is, again, a function of the current distressed pricing; non-agency mortgages have extremely low duration. In fact, many believe the bonds have negative duration because an increase in interest rates would likely correspond to improving inflationary expectations which would be positive for underlying home prices. Though deflationary pressures have weighed on interest rates in recent years, inflation expectations have been on the rise this year and an increase in rates could pose large losses for high-duration instruments such as Treasuries or investment grade corporate bonds.
Asset prices have benefited tremendously so far this year from the LTRO issued by the European Central Bank, as well as improved economic fundamentals in the U.S. economy. However, asset prices today largely reflect this change in outlook and many investors are left scrambling to find remaining attractive risk-adjusted yield. The non-agency market is compelling in this respect in that it still incorporates a negative economic outlook in current pricing and offers high cash-on-cash yields. The market is dislocated, the securities complex, and there is large potential for trading gains. In short, yields are still high even with conservative expectations and the market offers a rich hunting ground for alpha.
Sam Diedrich, MBA, MS, CQF, is an Associate Director and Portfolio Manager for the Fixed Income Relative Value strategy at PAAMCO. He is responsible for manager research and portfolio construction within the strategy. In addition, he also serves as the main point of contact for certain institutional investor relationships. Prior to joining PAAMCO, Sam worked as an electrical engineer for the Johns Hopkins Applied Physics Laboratory (Laurel, MD). Sam received his MBA from the University of Chicago Booth School of Business, his MS in Electrical Engineering from Johns Hopkins University, and his BS in Electrical Engineering (Distinction) from the University of Washington.