As U.S. treasury yields have been pushed significantly higher than their previous lows, those who have held mortgage backed securities and other secured credit have been in a fix to hedge their positions in a market with sudden rising rates. Long term Treasuries and MBS rates have taken a beating with the Federal Reserve’s consistently confusing comments on whether a taper or no taper is in the books.


Markets are a Racquet Ball for Bernanke

If the existing murkiness were not enough, Bernanke chose to add further to it in his speech on Wednesday. His promise of continuation of the $85 billion asset purchase program for the foreseeable future elevated stock and bond markets yet again. Ten-year Treasury notes fell to 2.57 percent as markets opened on Thursday, from 2.63 percent on Wednesday. This comes after the same markets did the exact opposite, i.e, Treasury yields surged higher and MBS experienced a steep selloff with a better than expected jobs report on July 7.

The reason we have been saying that hedge funds who trade asset/mortgage backed securities will suffer is because as long term rates go higher, the cost of refinancing their MBS holdings also increases. Funds who did not hedge their positions and took high risks in buying agency MBS in the comfort of the Fed’s easing look to lose the most. If the Fed indeed tapers, the agency MBS purchase program will also fizzle out, reducing demand for the asset class. Hedge funds that trade MBS/RMBS and are underperforming amid taper fears will look to unload their assets in an illiquid environment to entertain the redemption requests from their spooked out investors.

Mortgage Hedge Funds Decline in June

Hedge funds which invest in MBS, ABS and RMBS  and underperformed in the last month include Deepak Narula’s MetaCapital Mortgage Opportunities. The fund has lost 7.8 percent to the end of June. Steve Kuhn’s Pine River Liquid Mortgage Fund with $961 million under management, lost 1.7 percent in June, pulling the YTD performance to -3.3 percent. Pine River Fixed Income also lost 1.4 percent in the same period, however the $3.5 billion portfolio is up 6.6 percent for the year. Pine River’s funds were the star performers of last year, however their YTD returns however are just a shadow of the +30 percent gains they netted in the mortgage-friendly times of 2012.

Halcyon offshore Asset Backed Value Fund was down 1.15 percent to mid-June, the $2.7 billion fund is up 5 percent YTD. The IAM Credit Opportunities Fund has been on a losing streak for the past two months, the fund lost 0.47 percent in May and then again dropped -0.9 percent in June, and YTD return is now down to -0.4 percent.

CQS ABS Feeder Fund also took a loss of 1.37 percent in June, taking the year to date return to +5.26 percent. The fund aims to find cheap ways of hedging investments in asset backed securities. CQS ABS Feeder Fund manages $1.7 billion

Henderson Japan ABS Return Fund was down 1.38 percent to the end of June; the fund is up 12 percent for the year however. MKP Credit Offshore Fund lost a whopping 4.55 percent in last month—the fund manages $1.6 billion and is up 5 percent YTD.

Future of Mortgage Investors

Mortgage focused funds and their future was a major point of discussion in this year’s SALT conference held in Las Vegas. While most of the fund managers who run such vehicles remained upbeat about the future of investing in MBS, Troy Gayeski, senior PM at SkyBridge Capital, said that his firm is going to pare back its exposure in mortgage investments. Gayeski expressed his less-bullish view of mortgage market while talking to CNN Money’s Stephen Gandel.

The popular thesis among those bullish on mortgage markets is based on the possible liquidation and/or shrinkage of giants, Fannie Mae and Freddie Mac. Fund managers like Josh Birnbaum of Tilden Park have said that as these lenders are scaled back, it would become more expensive for banks to loan mortgages, thus making new opportunities for hedge funds.

Birnbaum’s Tilden Park Offshore was unsurprisingly the best performer of last year—the fund took a 41 percent gain in 2012. The $1.4 billion fund was up 14 percent through the end of May this year. Other than top mortgage market investors like Steve Kuhn of Pine River and Josh Birnbaum, hedgers like Dan Loeb also see value in mortgage investments. At the SALT conference, Dan Loeb said that $2 billion of his $11.7 billion Third Point fund was invested in mortgages and other consumer credits.

Of course these comments were made before the Fed started giving out its see-saw statements on a possible taper. While the contraction of Fannie Mae – Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac – Federal Home Loan Mortgage Corp (OTCBB:FMCC) could be bullish for hedge funds, the absence of $85 billion from Fed in free money can certainly make matters worse for mortgage investors.