Hedge funds exiting housing mortgage debt as prices rise

Boston

HEDGE funds that profited on residential mortgage debt after the financial crisis such as Pine River Capital Management and Canyon Partners are trimming their bets as prices rise.

Gorelick Brothers Capital is also exiting investments in both uninsured and government-backed home loan securities. The firm is seeking higher returns by raising a private equity fund to buy single-family rental houses, said Rael Gorelick, a co-founder of the firm.

Hedge funds that took a risk on distressed mortgage debt after the 2008 housing crash have had robust returns. Canyon Partners made US$7 billion on non-agency securities in the decade before and after the financial crisis. Now these firms see dwindling opportunities as investors crowd into the market and issuance declines, pushing up prices of the non-agency debt.

"Spreads got tighter over the past few years," said Colin Teichholtz, co-head of fixed income trading at Minnesota-based Pine River, which manages US$15.5 billion. "It has gone from a great opportunity to a mediocre one."

Returns at hedge funds that buy asset-backed securities, often including mortgage debt, averaged 10.2 per cent last year, down from 13 per cent in 2013, according to data compiled by Bloomberg.

Pine River cut its exposure to non-agency mortgage-backed securities (MBS), including sub-prime, from more than 40 per cent in 2011 to below 10 per cent today, Mr Teichholtz said. The firm bought the debt at depressed prices after housing prices plummeted, and again in 2011 and 2012 when banks came under regulatory pressure to reduce their holdings.

"Even as that was happening, our mindset was that this cheapness couldn't persist forever," said Mr Teichholtz, whose firm continues to invest in agency MBS.

Prices of non-agency debt have increased 176 per cent from a low of US$29 in April 2009, according to the ABX index. Some types of sub-prime mortgage securities offer projected yields of 5.8 per cent, down by 0.5 percentage point from mid-2014, according to Bank of America data. In the wake of the financial crisis, yields often exceeded 20 per cent.

Pine River and other hedge funds are searching for higher yields in other markets, such as commercial mortgage-backed securities (CMBS) and collateralised loan obligations.

"Both those markets have a significant amount of new issuance," said Manish Valecha, head of research at Gapstow Capital Partners, which invests in mortgage hedge funds.

Moody's Investors Service expects new CMBS issuance to reach US$110 billion this year, driven in part by 10-year loans from 2005 coming due and strong deal activity. Issuance of CMBS could increase 40 per cent to 50 per cent this year compared with 2014, said Mr Teichholtz.

Canyon Partners cut its holdings of non-agency securities to about US$4 billion as at Dec 31, down from US$6.5 billion a year earlier, according to a marketing document obtained by Bloomberg News. The Los Angeles-based firm's bet on the debt has produced a gross profit of 27 per cent per year since 2005.

Investors at SkyBridge Capital and Gapstow Capital said they're keeping their money in non-agency MBS because the debt is still attractive compared to other types of securities.

"If you want to move out now, the question is where would you go?" said Troy Gayeski, the senior portfolio manager at New York-based SkyBridge, which invests in hedge funds.

Junk bonds, which have more risk, are likely to make 2 per cent to 5 per cent this year, he said.

In 2013, SkyBridge started reducing its exposure to the securities because it saw more opportunities in event-driven equity, which involves companies undergoing transformations such as spin-offs, mergers and acquisitions. Those returns have come down, which caused SkyBridge to start increasing its exposure to non-agency securities in the second quarter of last year.

Mr Gayeski said he expects the mortgage securities that trade at a discount to par to produce a return of 6 per cent to 10 per cent this year.

Gapstow Capital, which invests in mortgage hedge funds, is also keeping its money in non-agency MBS because the sector looks more attractive than high yield debt, where there is a lot of volatility, said Valecha.

Gorelick Brothers, which started two funds of hedge funds in 2008 and 2010 to take advantage of the steep decline in mortgage-backed securities, is redeeming its investments and handing the capital back to investors.

Mr Gorelick said his North Carolina-based firm is searching for higher absolute returns by purchasing and renovating single family homes. He expects to receive steady income from rent payments, while eventually taking advantage of rising prices in the housing market by selling the homes. BLOOMBERG