Daily Speculations

The Web Site of Victor Niederhoffer & Laurel Kenner

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7/20/04
Good Times and Bad Times by a Musical Spec

One of the first trades I ever saw, upon my entry into the bond world, was what I'd call the "mortgage cheapness trade". The trick was to sell prepayment risk (by buying various forms of mortgage-backed securities), and continually rebalance the exposures in the mortgage bonds. The winners in this trade (e.g., the hedge fund where I used to work, and others like it) had better analytics and a better understanding of the risks than the next guy, and they were able to capture the cheapness in the bonds. The nice thing about cheap bonds is this--you are paid to hold them! So even if the securities are not repriced by the market, you can sit there and wait and earn what Vic would term an "overplus". It was good to be a bond "arb" guy.

There were other aspects to the mortgage cheapness trade. You could build up a position in mortgage TBAs (effectively mortgage futures) where you were owed more bonds than the market had to give you. So you could cause a short squeeze in cheap bonds! What a great thing - you're a bond guy, you are paid to sit around and wait with these cheap bonds, and, on top of that, you can squeeze the people who are short to you, goosing up your already great returns. It was good to be a bond "arb" guy.

Unfortunately, everyone else caught up, as you knew they would. The knowledge of these bonds, and how to extract the "overplus" from the mispriced option was disseminated. And sure enough, the bonds repriced. Those who held them had more phenomenal performance, but looking forward their "bread and butter" trades were not there. What's a bond "arb" guy to do?

Is there still value in these bonds? Sure. They get out of whack from time to time, and you can build a nice position to take advantage of it. But to get your returns you have to do much, much larger size--and with larger size comes a much larger exposure to the fat tails of the distributions... and exposure to credit seizures, and ridiculous margin calls, and, well, you know the drill. It can be really bad to be a bond "arb" guy.

So this mortgage trade--buy cheap bonds, and squeeze the market--is now a macro trade. I saw it work again in 2001, but for a different reason. Here the bonds weren't as cheap as they once had been, but the view worked because rates dropped dramatically. The holder of "futures" on high-coupon mortgages did very, very well because they weren't making any more high-coupon mortgages! So the bonds that were deliverable into the contract were disappearing, and disappearing quickly. Same result for the bond "arb" guy, but for a different reason.

But market ecology is amazing--where big funds are too big to care about bonds that are a few 32ds cheap (they get lost in the shuffle), a smaller fund that can suss out these cheap bonds can tuck them away and provide nice returns. And sure enough, the boutique mortgage hedge fund is out there. They are doing the same kind of trade, but in smaller size--picking up the scraps from a carcass that was slain by animals much larger than it. This smaller predator will grow strong, and leave room at the bottom for another to pick up the pieces.

So what does it mean for me? I think it will be easier, going forward, to make money with good macro decisions. I think Vic has the right idea--trade directionally in big, liquid markets. Will "arb" strategies come back? Well, maybe, but there are an awful lot of really smart people (with better access to information and capital than I) who are chasing these returns.

Now if I could only make good macro decisions.