Times are good — in some quarters.
The yield curve has steepened, volatility has soared, and Mustafa Jama, chief investment officer at Morgan Stanley Alternative Investment Partners, a $12 billion fund of hedge funds, is happy to see it.
For at least three years — through last summer — a flat yield curve combined with record low volatility to leave slim pickings for hedge fund managers who look for relative value among fixed-income securities. But a sharp uptick in volatility and a suddenly steep yield curve — thanks to the aggressive easing by the Federal Reserve Board, which has pushed overnight interest rates down 225 basis points since last August (and is expected to drop rates further this month) — have revived relative-value trades and other staples of fixed-income arbitrage. As the yield curve steepens, managers not only have opportunities to exploit price anomalies but can also expect them to move back into line faster. A steep curve also allows managers to borrow at low short-term rates to buy longer-dated bonds that pay a higher interest rate and then pocket the difference.
“People have made tons of money as the yield curve has steepened,” says Jama, whose group is based in West Conshohocken, Pennsylvania. “They were long the two-year Treasury and short the ten-year.” He notes that both fixed-income arbitrage and macro managers have exploited a trade that may have further to go if the Fed continues to cut short-term rates while inflation fears push long-term rates higher.
For fixed-income arbitrage managers, relief could not have come soon enough after investors deserted them in droves on the heels of disappointing returns in 2006. “Many fixed-income arb managers either closed down or really sized down,” says Jama. “For the past three years, it was one of the most difficult places to be.”
The fundamentals explain why. When the yield curve flattens, the classic carry trades — those that involve borrowing short to buy longer maturities — become less profitable and eventually uneconomic. Low volatility crimps margins on relative-value trades, too, because when prices aren’t moving much, they aren’t moving relative to one another, either.
It’s a different story now. The Fed has sharply lowered its overnight lending rate since the fall — from 5.25 percent in September to 3 percent as of early February to inject liquidity into financial markets it says “remain under considerable stress.” That stress, of course, has brought the spike in volatility, which Jama says has breathed new life into relative-value trades.
But he notes that prime brokers have clamped down on lending against mortgage-backed securities, a trend that has squeezed the margins in mortgage arbitrage. “The managers are scared of being flushed out of positions,” Jama explains. “They have brought down the leverage, and when you do that, the returns are not as attractive.”
Not everyone is as enamored of fixed-income arbitrage as Jama, however. Stephen Vogt, chief investment officer at fund-of-hedge-funds manager Mesirow Advanced Strategies in Chicago, avoids the approach because its practitioners often use a lot of leverage, borrowing as much as 20 times their capital. It’s a calculated risk, of course: Managers who trade virtually risk-free Treasuries can tolerate higher leverage. If they are playing on-the-run Treasuries (the most recent issues) against off-the-run securities (older issues of a similar maturity), extreme leverage may be acceptable because the prices must eventually converge. The strategy isn’t without risk, however, as the 1998 collapse of Long-Term Capital Management vividly showed.
It’s what happens if spreads widen in the interim that concerns Vogt. He says the danger ratchets up for managers who use the arcane trick of trying to isolate the prepayment risk in mortgage-backed securities, another common fixed-income arbitrage strategy. They can hedge interest rate risk by selling Treasuries short, but a credit crunch can cause losses on both long mortgage-backed securities and short gambits — as recent events have proved. “It looks like a nice, steady arb position, but you are long a mortgage and effectively short a Treasury of similar duration,” Vogt says. “In a flight to quality, everybody moves to Treasuries, and risk premiums widen on the mortgage side.” In a highly leveraged portfolio, it doesn’t take a big move to trigger margin calls and force a manager to sell positions at a loss.
“Today,” Vogt says, “more-sophisticated leveraged relative-value trades are even more problematic, as financial crises can create a liquidity-driven sell-off in the higher-quality long position and covering of the poorer-quality short position.” Investors learned that the hard way in blowups like LTCM and the one in February at London-based hedge fund Peleton Partners.
The danger is far less severe for players in fixed-income arbitrage who focus only on a strategy involving interest rates, currencies and volatility but avoid credit risk. Brevan Howard Master Fund, the $17.5 billion flagship fund of London-based hedge fund manager Brevan Howard Asset Management, has about 80 percent of its assets in Group of Seven interest rates and foreign exchange. From inception in April 2003 through March 2007, the fund had a 10.5 percent annualized return after fees despite rising interest rates, flat yield curves and low volatility. When Brevan Howard raised $1.3 billion in an initial public offering of a feeder fund, BH Macro, listed on the London Stock Exchange in March 2007, the firm told investors — no promises, of course — that in more-favorable market conditions returns could exceed 20 percent.
And so they did. When the credit markets began to unravel in June, the Brevan Howard Master Fund had the wind in its sails: From June through September it racked up monthly returns in excess of 2 percent, including a 5.97 percent return in September alone. The fund was up 25.21 percent in 2007, and the run continued into this year (it was up 9.89 percent in January and 7 percent in February).
Performances like that don’t come from owning conventional bonds. Like most fixed-income hedge funds, Brevan Howard uses options, futures and derivatives to generate leveraged returns. And although the firm got the market spectacularly right, many fixed-income funds didn’t fare as well even if they shared the view that short-term interest rates would fall. Managers who chose to play the trend through LIBOR futures, for instance, were disappointed, as a global shortage of liquidity kept LIBOR high while both the overnight Fed fund and short-term Treasury rates tumbled.
But arbitrage opportunities — as Jama and others note — abound in credit-sensitive instruments, too. Peter Hornick, head of U.S. collateralized debt obligations and structured credit at Lehman Brothers, says hedge funds were persistent sellers of “illiquidity premium” from 2002 through the middle of 2007: They typically bought subordinated bonds and sold senior debt as a hedge; bought single-name credit default swaps and sold an index short; or bought mezzanine layers of structured-credit vehicles and either sold the underlying single-name credits in the portfolio or bought puts on an index. Hornick says he sees a tremendous opportunity for hedge funds in the distressed-structured-credit market. Veteran distressed-credit players who know corporate capital structures have begun to build the technology to better analyze the holdings of CDOs, the pools of debt worst affected by the subprime meltdown. Today a hedge fund might buy the triple-A tranche in a CDO and short the single-A tranche as a hedge, for example. “In securitized vehicles you want to bet that losses will stop below where you are long but will impair where you are short in the capital structure,” Hornick explains. “Hedge funds are going to pounce on that.”
The trick will be to finance the positions, and whoever gets there first will have a huge advantage.
Meanwhile, some managers have discovered ways to generate double-digit returns in fixed-income arbitrage without huge leverage. David Edington, managing director and chief investment officer of Rimrock Capital Management in San Juan Capistrano, California, has developed an eclectic bifurcated portfolio structure, part of which extends fixed-income arbitrage to riskier positions that cannot support high leverage. To create what he calls an “income engine,” Edington buys short-term bonds that have maturities anywhere from nine months to three years, an overlooked sector that delivers most of the return available on longer-dated bonds, with far lower volatility.
“You get paid more than can be explained by risk premiums at the front end of the yield curve,” Edington says. “It’s an anomaly.” Short-dated bonds essentially eliminate the need for a quick exit strategy because Rimrock typically holds them to maturity.
Edington, who has managed fixed-income portfolios for more than 20 years, including a stint at Pacific Investment Management Co., one of the world’s biggest bond shops, also likes to trade the Treasury bond spread between cash and futures. He may buy a cash Treasury security and then hedge by selling a futures contract against which it is deliverable. “You are buying in the OTC market and selling into the exchange via the futures contract,” he says. “Sometimes the prices get out of line.” The positions create a steady cash flow, which he leverages by about two times its value to deliver returns that can approach 10 percent.
To add to the mix, Edington, whose hobbies happen to include surfing, tries to catch the wave on what he considers the two or three best trading opportunities that come along every year. The first of his three funds looks for total-return plays in any asset class, but Rimrock offers a second fund to investors who prefer to limit their bets to the firm’s fixed-income expertise. In theory, each fund can reasonably be expected to earn close to 20 percent returns if the trades deliver, but if Edington is wrong, his income engine provides a cushion even in a bad year. Experience supports the premise; Rimrock has not had a down year since its founding in 1999 (and returns in its best years topped 20 percent).
One key to Rimrock’s recent performance was its long position in interest rate options, which Edington bought as a play on volatility. The position was a natural hedge because volatility is often inversely correlated to bond prices. Edington wasn’t persuaded by the rosy arguments that policymakers had learned from past mistakes, more central banks were free from political interference and a global glut of capital would support asset prices. “Options prices were absurdly low by any historical standard in a world that seemed fraught with peril and leverage,” he says.
Another successful hedge in 2007 was selling short the subordinated debt of Fannie Mae, a company originally sponsored by the government that buys qualifying mortgages. Edington saw one part of Fannie Mae’s business as “a 30-times leveraged monoline hedge fund that owned conforming mortgage-backed securities at a time when spreads on an option-adjusted basis were as narrow as they had ever been,” while the other part “received fees for being in a first loss position on $2 trillion of U.S. mortgages in a housing bubble.”
He argues that Fannie Mae’s implicit government backing might extend to its senior debt, but adds that if the housing market tanks, the subordinated debt will probably not be guaranteed. Yet when he put the trade on, it cost a relatively inexpensive 20 basis points per year to short the subordinated debt. “Our theme was to find cheap insurance,” Edington says. “A year ago there were so many things like that, it was difficult to pick the best.”
Today, Rimrock has about $300 million under management: $200 million in its first two funds and $100 million in a fund launched in January to exploit mostly long opportunities among senior tranches in subprime mortgage bonds. Edington argues that if cumulative mortgage credit losses impair the senior notes to the extent that current deeply discounted market prices imply, Fannie Mae and Freddie Mac will be bankrupt, a wholly unlikely circumstance. “The whole world is not pricing to the Great Depression,” he says.
Fixed-income arbitrage takes yet another twist at Structured Portfolio Management, a Stamford, Connecticut–based firm with $800 million in assets. SPM specializes in mortgage arbitrage, mining the risk premiums related to mortgage prepayments.
SPM founder and CEO Donald Brownstein says that with real estate values falling, lenders won’t make a loan unless the borrower puts up 20 percent, so anyone who bought at the top of the market may have to come up with additional cash to get a new loan. This is anything but attractive to homeowners, who may also balk at putting more money into a declining asset. Most will not refinance under such conditions, which pushes out the expected duration of mortgages — and the bonds they support.
And that is why Brownstein now owns prime-quality, interest-only mortgage-backed securities, which pay the interest component of a mortgage payment for as long as the mortgage is outstanding. “The IOs won’t prepay, which means they are more valuable,” says the CEO, who hedges out interest rate risk in such holdings by buying Treasury futures. Such a strategy involves a complex calculation in which the credit quality of the borrowers is crucial.
“Grandma can’t do this stuff,” Brownstein says. “You have to look at it piece by piece. It is very detail-oriented.”
