Flexibility in Structured Finance
Braddock Multi-Strategy Income Fund
Author: Ticker Magazine
Last Update: Sep 08, 10:58 AM EDT
|Asset-backed securities, including mortgage-backed securities, are a special area of the fixed-income space that demands specialized knowledge and experience in credit markets and the economy. Garrett Tripp, portfolio manager of the Braddock Multi-Strategy Income Fund, relies on a flexible and opportunistic approach to find securities that offer the best risk-reward profile.
“Our approach to investing can be described as opportunistic in that we seek investments offering the best risk-reward profile.”
Another area we carefully evaluate for both seasoned and new issue securities is the servicing agent. There are a number of loan services that we monitor.
It is also important to know the securitization trustee to ensure that they will provide timely information back to bondholder. We receive monthly reports which tell us how much principal and interest was collected from the underlying loans and how that money was distributed to the various bonds associated with that trust. We have to track that information to make sure that it’s done correctly each and every month.
Q: Do you rely on rating agencies or on an internal rating system for researching bonds?
There is no doubt that the rating agencies had a tough time during the financial crisis and lost credibility as did most loan originators. But bond agency ratings are still very important because they help determine the market demand for the securities. Before we invest, we need to determine the potential depth and liquidity of the buyer base for a bond. The closer it is to an AAA rating and the more liquidity it has and the larger will be the potential buyer base.
As ratings can improve as the bond ages, ratings help us understand not only who is interested today, but will be interested in owning the bond in two or three years. For the securities for which we have a potential interest, we monitor the seasoning and how that may affect the future price.
Q: Is the anticipation of a rating revision a good investment opportunity?
Yes, ratings migration is part of our strategy. For instance, suppose we buy a bond that we believe is underrated at BB when our credit estimate is BBB. If that bond is upgraded in 18 to 30 months to a BBB or even an A as we anticipate, we will profit from the capital appreciation.
Q: How do you utilize macroeconomic indicators in your investment strategy?
Although we carefully monitor a variety of economic indicators, our primary focus is the U.S. housing market and the consumer side of the economy. On an ongoing basis, we track indicators like U.S. household formation rates and changes in mortgage applications.
One of the most important indicators we follow is the Mortgage Bankers' Association’s Mortgage Credit Availability Index. It provides an indication of how strict current guidelines are for getting a mortgage.
For the U.S. homebuilding industry, we maintain a general supply and demand profile. At the current time, with household formation exceeding new construction, we expect housing and mortgage finance to demonstrate strength over the next five to 10 years.
On the consumer side, we follow statistics like consumer default rates, debt-to-disposable income, personal savings-to-disposable income, and consumer confidence. The numbers suggest that the U.S. consumer is currently well positioned to service their credit card and mortgage loan payments.
Q: Can you describe a couple of security sectors that highlight your research process?
One area of interest is the Credit Risk Transfer deals (CRT) undertaken by the government-sponsored entities like Fannie Mae and Freddie Mac. The bonds are issued to help the government unload some of its direct debt obligations. Roughly 80% of new home loans today are held by Fannie Mae and Freddie Mac, which puts a taxpayer on the hook for most of the countries potential mortgage defaults.
So, the government initiated a credit risk transfer program to transfer some of that mortgage risk back to investors. We started participating in these deals when they started in 2013, with investments across the mezzanine and subordinated debt stack. And the deals have worked out well.
The mortgage pools underlying these bonds are experiencing exceptional performance with delinquency rates from 15 to 35 basis points—well under 1%. In addition, the number of institutional and money managers investing in this space has grown over time which has led to excellent liquidity. It has not only been a profitable investment, but it has had the added benefit of being all floating-rate paper.
Another area of interest, although much smaller, has been debt backed by home rentals. Following the financial crisis, mortgage loans became difficult to obtain. As a result, many households turned to renting single family homes. Several publicly-traded REITs were formed that purchased large numbers of homes and offered them as rental properties. They financed their purchases by issuing bonds that were backed by the monthly rental revenue. If the REITs were unable to service the debt, the bondholders could foreclose on the underlying houses to pay back the debt.
In the last few years, vacancy rates have fallen, rental rates have increased, and the debt has performed extremely well. When we bought those bonds, they were rated BB and now many of those bonds are investment grade.
Q: What is your outlook for existing home sales and new home construction?
I believe that existing home sales are back to the overall level that we saw before the crisis, but new home sales are still lagging slightly. It has taken the homebuilders a long time to get comfortable building homes as the profit margins remain thin. Also, when we look at entry level homes, it has been harder for first-time home buyers to find homes that are affordable and then to secure financing.
Moreover, the amount of inventory on the market is very low compared to historical norms. The home ownership rate has fallen from over 69% to 63%. So, we really do need to see a boost in home construction to satisfy the rate of household formation.
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