Other complex, yet efficient, trades employ specific instruments from the mortgage-backed securities market, either in isolation or in their relationship with the government bond market, to express both directional and non-directional views on interest rates. Part of the complexity common to trades involving MBS is that their success crucially depends on both the selection of the right securities and their subsequent active trading.
A possible trade is to go long Treasuries and short specific types of MBS securities, to play the widening of the mortgage basis, the spread between Treasury and specific mortgage-backed security (pass-throughs) total return profiles. On the plus side, due to the positive convexity of the overall position, this trade is expected to be profitable, at least in the short term, for sizable rate moves in either direction. Furthermore, it provides a long exposure to political risk through expected additional profits should any new U.S. government-sponsored streamlined refinancing program be enacted. The trade is, however, at risk from the continuation of Fed tapering being focused solely on its Treasury purchases (unlikely) or a reduction in the pace of expected Fed tapering or an increase in Fed purchases if the economy weakens dramatically. Any of these Fed actions could in theory lead to short-term losses. However, at these price and spread levels expected losses would be extremely modest in comparison to potential upside.
An alternative trade, still involving the MBS market, is to express a directional view on rates using interest-only MBS and swaptions. Here, the “optionality” attribute of the swaptions determines the main drivers of profit and loss for this trade and the interest-only MBS securities provide positive carry. It should be noted this trade has a short exposure to the political risk concerning MBS refinancing, hence it is going to be hurt by any new streamlined refinancing program.
Last of these types of trades is a positive carry long position in interest-only MBS hedged with Treasuries. This does not explicitly express a directional view on rates. Instead, it provides an implicit view on rates since the already attractive positive carry streams should increase over time as interest rates rise. This is due to a decline in refinance activity that would come from higher interest rates and the further reduction of political risk in the form of any new U.S. government-sponsored streamlined refinancing programs. There are, however, three main drawbacks to this trade. First, the negative convexity of the core assets, which requires a high level of proficiency in hedging rate moves. Second, profits from the trade might take awhile to materialize because large rate moves higher tend to increase price volatility which, in turn, can result in short term mark-to-market losses in the position. Third, the trade is short U.S. housing market political risk as well.
There is a range of options to guard against rising rates. How investors approach this challenge depends on their individual requirements, particularly the balance they decide to strike between simplicity and efficiency, and, of course, their view on the most likely future direction of interest rates.
Troy Gayeski is a partner and senior portfolio manager at SkyBridge Capital, New York.