Providence mortgage backed security (MBS) fund, which focuses on MBS arbitrage strategies, has returned 1.4 percent for March 2013 and 5.4 percent year to date. Interest rates in 2013 have been unchanged from year end as the U.S. Federal Reserve continues to buy longer dated Treasuries and low coupon Agency MBS. These securities have underperformed recently falling in price year to date through March 31, 2013. Market participants have been surprised by such underperformance and they have started to price in an eventual ending to the Federal Reserve’s LSAP (Large Scale Asset Purchases) program. Fed officials mentioned tapering of asset purchases last quarter as a possible response to improving economic and financial market conditions, shall they occur.

The Providence MBS fund has gained as a result of the underperformance of agency MBS and longer dated (maturities of 7 years or more) U.S. Treasuries. Russ Jeffrey, Principal, CEO and Chief Investment Strategist of Providence, opines the long levered MBS trade some investors have been holding may be stretched in terms of future upside.

William Michaelcheck Fixed Income

William Michaelcheck

Another beneficiary of low yields and fears of potential interest rate hikes is Mariner Investment Group, a $10 billion multi-strategy hedge fund manager. Mariner’s founder and Chief Investment Officer, William Michaelcheck, advocates trimming low yielding corporate and government bonds. He recommends fixed income trading oriented strategies, including but not limited to fixed income and credit arbitrage, agency mortgage trading, and volatility trading. Regulatory changes, such as the upcoming implementation of the Volcker rule, have made arbitrage strategies more attractive.

Pre- financial crisis, major banks proprietary trading desks dominated fixed income oriented trading, making price discrepancies small and fleeting due to the desks’ trades size, volume, and frequency. Hedge funds had to take more risks to achieve reasonable returns. Now, without the large proprietary desks dominating the market, price discrepancies and wider spreads will likely last longer providing opportunities to profit.

Mariner is also seeking to transfer risk from European banks to its investors by engaging in “regulatory capital relief transactions”. These consist of creating structures and pricing them accordingly to transfer risk to hedge fund clients that will not require the bank to sell assets or scale back loans. European banks need to adjust their capital by either increasing their capital cushion or getting rid of capital intensive assets to make their balance sheets comply with Basel III requirements, which will be gradually phased in through 2019.

The uncertainty in fixed income markets is providing opportunities for traders to profit from higher volatility. In turn, fixed income arbitrage strategies may provide returns that will not go together with price declines in stocks and bonds when interest rates rise.