October 9, 2012 1:59 pm

Structured credit a boon for investors

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US Federal Reserve building©Bloomberg

As Congress bickered, the Federal Reserve, on Constitution Avenue above, followed an ultra-loose monetary policy to keep the economy afloat

One hedge fund strategy has stood out for its performance ahead of all others this year: structured credit.

While stockpickers have been too cautious to embrace a rallying US stock market, macroeconomic watchers have lacked big trends and event specialists have twiddled their thumbs, asset-backed fixed income has been the place to be in 2012.

The strategy was the only area to show double-digit gains by the end of September, according to data provider HFR – up 13.3 per cent while the average hedge fund has made just 4.7 per cent for its investors after fees.

Those double-digit returns are thanks partly to the policies of the Federal Reserve to force down interest rates, which have pushed investors to buy risky assets in search of yield.

Structured credit – bundles of debts such as credit card receivables, car loans and mortgages that are then sliced into securities offering different levels of risk and exposure to losses – offers the steady stream of interest payments that are now in high demand thanks to the Fed’s open-ended commitment to support the US economy.

“Investments in virtually all the securitised products sectors fit well with the central banks’ ‘lower for longer’ policies,” says Mary Kane of Citigroup.

Furthermore, Mayer Cherem of Paamco, a fund of hedge funds group, says the commitment by the Fed to buy $40bn of mortgage securities guaranteed by the government every month has forced investors to look for alternative long-term securities with good collateral and fixed interest rates.

“People need to replace their Treasuries and agency mortgages with things that look like Treasuries and agency mortgages,” Mr Cherem says.

At the same time US economic fundamentals have been improving, with housing leading the charge six years after prices started to collapse.

The Case-Shiller index of home prices in 20 American cities rose 6 per cent in the first half of the year. During the second quarter alone, the number of “underwater” houses worth less than their mortgage dropped to 10.8m from 11.4m, according to housing data provider CoreLogic.

In addition, mortgage servicers have shifted troubled loan management to specialists such as Ocwen, producing better recovery values for bondholders through early sales and modifications.

So values for securities tied to low-quality mortgages that collapsed in 2007 and 2008, precipitating the financial crisis, have recovered strongly this year.

For instance, Third Point, the hedge fund run by Dan Loeb, said in a letter to its investors this month that its subprime holdings were up 23 per cent so far this year.

“Undoubtedly, investors have seen a flurry of news articles about improvement in housing prices and correspondingly identifying mortgage-backed securities as the hottest area for credit investing,” it said.

The sector was also helped by a reversal of sentiment from the volatile markets of last year. The Fed had begun to sell its portfolio of Maiden Lane securities (related to the bailout of American International Group), which had a face value of more than $40bn in 2011.

However, investors retreated from the market in the face of the sales and as dealer banks cut inventories to prepare for new capital requirements. Trading volumes collapsed and prices for some residential-backed securities halved, creating this year’s opportunity.

Colin Teicholtz, portfolio manager at Pine River, says that at the beginning of the year the spread between a typical subprime bond and high-yield corporate debt was around 800 basis points.

“It seemed to us that there was way too much risk premium in the market.” That spread has now come down to around 400 basis points. “It’s not going to zero, but there is still room for that basis to tighten more,” he says.

The market rebound has been a boon for hedge funds as such complex securities, which trade at a steep discount to their face value, offer much more opportunity to add value by picking and choosing than say, high-yield debt, where most bonds trade close to par.

However, a lack of new issuance presents a longer-term problem. Where once there was more than $1tn issued every year, the outstanding value of non-agency bonds is now less than $1tn in total as mortgages are paid down, refinanced and foreclosed.

For now, though, a stable market environment and improving economic fundamentals will support asset-backed securities, says Ms Kane.

“Ironically the global slowdown, the European debt crisis and the looming US ‘fiscal cliff’ are reinforcing the market’s resolve to remain short and high quality, and reinforcing asset-backed security performance,” she says.

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