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 $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, the co-head of fixed income trading at Minnesota-based Pine River, which manages $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% last year, down from 13% in 2013, according to data compiled by Bloomberg.Pine River cut its exposure to non-agency mortgage-backed securities, including subprime, from more than 40% in 2011 to below 10% today, 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 Teichholtz, whose firm continues to invest in agency MBS.
Prices of non-agency debt have increased 176% from a low of $29 in April 2009, according to the ABX index. Some types of subprime mortgage securities offer projected yields of 5.8%, down by 0.5 percentage points from mid-2014, according to Bank of America data. In the wake of the financial crisis, yields often exceeded 20%.
Pine River and other hedge funds are searching for higher yields in other markets, such as commercial mortgage-backed securities and collateralized loan obligations.
"Both those markets have a significant amount of new issuance," said Manish Valecha, the head of research at Gapstow Capital Partners, which invests in mortgage hedge funds.
Moody's Investors Service expects new CMBS issuance to reach $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% to 50% this year compared with 2014, said Teichholtz.
Canyon Partners cut its holdings of non-agency securities to about $4 billion as of Dec. 31, down from $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 gross profit of 27% 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% to 5% 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 spinoffs, 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.
Gayeski said he expects the mortgage securities that trade at a discount to par to produce a return of 6% to 10% 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.
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.
There's an undersupply of single family homes and apartments to rent for the first time since 2001, Frank Nothaft, chief economist at CoreLogic, said in December when held the same title at Freddie Mac.
The shortage is benefiting institutional investors who spent more than $25 billion since 2012 on buying homes to rent. Rents on all single family homes and multifamily units are expected to climb 3.5% this year, compared with a 2.5% increase for home purchase prices, according to December estimates by Zillow Inc. chief economist Stan Humphries.
Gorelick said the opportunity in single family homes is similar to the environment for non-agency bonds in 2010, when debt could be purchased with an implicit discount to collateral value.
"The value has moved from the debt to the equity," he said. "Only instead of a corporate balance sheet, we see this playing out in homes."
