Providence Investment Management, a hedge fund management firm, which focuses on Mortgage-backed arbitrage Strategy (MBS), believes that the market from which it bases its hedging strategy can offer better returns. In 2011, Providence was one of the best performing hedge funds. The firm reported a return of 20.5% on its $1.3 billion worth of assets under management. The fund is up approximately 1% this year.
The company points to the deteriorating mortgage and U.S treasury rates, which have hit an all time high in the recent past, as a major reason for the reduced repayment rate, which now, the firm believes to be very unpredictable as compared to a few years ago.
The Principal, CEO, & Chief Investment Strategist, Russ Jeffrey, connotes, home owners with strong credit scores benefit from the current low interest environment. Jefferey notes that, lower credit borrowers are unable to refinance. Consequently, this disrupts historical prepayment patterns and creates a large amount of relative value opportunities.
Nonetheless, Jeffrey believes that despite the existing predicaments to higher returns, the MBS market is return rich, and bases his argument on the following keynotes.
Cheap Funding: After the federal reserve declared it will keep the base rate at zero, at least for the next two years, there has been a significant decline in borrowing rates for investors.
Additionally, hedging has also become very inexpensive, notes Jeffrey, citing that it has never cost so little to hedge against duration, volatility, and other mortgage risks.
Furthermore, agency mortgages have attractive valuations and massive net carry: the firm reveals that MBS spreads are at historic lows oscillating at below “one” treasury yields.
Finally, Jeffrey points to high rate of liquidity, as capital is expected to continue flowing to the MBS space, which widens the potential for Fed mortgage purchases through Q3. The firm notes that it has positioned its fund in accordance with the alpha generating opportunities presented by the above conditions.