(Bloomberg) -- The Federal Reserve’s flurry of interest rate hikes is recreating the market conditions that helped mortgage investor Michael Vranos make his fortune in the early 1990s. Now, he is betting the same trades will help him win again.
The Fed’s current rate tightening cycle is reminiscent of the central bank’s actions nearly thirty years ago, when it raised rates by 300 basis points to 6%. This created the opportunities that allowed Vranos to set up a hedge fund now known as Ellington Management Group, named after his Connecticut hometown, betting on mortgage bonds.
“At that time, the Fed rate hike created opportunities that enabled us to launch Ellington, with a mandate of investing in undervalued mortgage securities,” Vranos said in a recent interview. “Today, we’re seeing very similar opportunities to put capital to work.”
The central bank has raised its key rate by 150 basis points this year in the most aggressive ramp up since 1994 in order to fight inflation, which hit a 40-year peak at 9.1% in June. And more jumbo increases are likely on the way.
Vranos, a former rising star at Kidder, Peabody & Co Inc. in the early 1990s, left in 1994 to form Ellington, which capitalized on the mass sell-off in mortgage securities following the Fed’s rate hikes. The credit crisis later knocked out Kidder, which at the time was Wall Street’s leading seller of mortgage bonds.
In 1996, when the US bond market was down by 2.3%, Ellington racked up annualized returns of 40% in the first four months of the year thanks to those bets, crowning Vranos as one of the most recognizable names in the mortgage bond market to date.
Two years later, the firm liquidated a large chunk of securities to meet lenders’ demands for more collateral after the fall of Long-Term Capital Management, reported Bloomberg at the time.
Bigger Bargaining Chips
The market for mortgage-backed securities has swelled to $9 trillion in size from $1.6 trillion since the 1990s, in tandem with other securitized assets. Structured products have also cheapened dramatically across the board this year, even toward the top of the capital stack, as uncertainty and volatility swirl following the Fed’s latest rate hikes.
“In today’s market, we’re seeing the double benefit of higher yields and wider spreads, giving investors opportunities in the double-digit range, which we haven’t seen in the last decade,” Vranos said.
As a result, Vranos is once again scouring undervalued securities, including mortgage-backeds, but this time, he has a wider array of options to choose from. “You are talking about a multi-trillion dollar market now,” he said.
The MBS market is also experiencing shocks as the Fed, traditionally the largest buyer of the bonds, retreats from the sector. The central bank has been cutting back on reinvesting principal, capping its monthly runoff at $17.5 billion until September, which means there will more securities in the market up for grabs.
“With quantitative tightening firmly in place, it seems like the government may be out of the hedge fund business for a while,” said Vranos.
There is value to be found outside of agency mortgage-backed securities as well, said Vranos, especially in non-qualified mortgage or non-QM bonds, credit risk transfer notes and collateralized loan obligations. And these asset classes have also grown fast.
The CLO and CDO -- collateralized debt obligations -- market ballooned to $262.5 billion last year, from $48.1 million in 1994, according to data from the Securities Industry and Financial Markets Association. The securities have significantly widened as well, with the safest tranche of US CLOs cheapening by 83 basis points so far this year, according to BofA Securities Inc.
The equivalent tranche of non-QM RMBS has also widened by 125 basis points this year, according to BofA, while spreads on commercial real-estate CLOs -- bonds backed by bridge loans from properties being built or renovated -- have increased by 133 basis points year-to-date.
“These are very low risk, high spread assets,” said Vranos, pointing to the AAA tranches.
He is also looking lower down the capital stack, where he says investors can get loss-adjusted yields of over 10% for CLO mezzanine bonds, and about 11.5% for top-tier BB CLOs.
On the commercial side, Vranos likes multi-family and diversified industrial debt: “There’s a lot of opportunity out there right now for long-term investors.”
With market participants predicting a further increase of about 75 basis points at the Fed’s upcoming meeting on Wednesday, spreads on these securities could keep widening.
“This should continue for as long as the Fed is in runoff mode, which might be until there’s some kind of crisis,” said Vranos. “And I don’t think a recession per se falls in that category.”
(Updates with 1998 securities sale in paragraph 7)
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