By Venk Reddy
Originally published in Q4 2017 letter
Wall Street has a long history of convincing investors that something complicated is the same as something simple, not always intentionally and usually with a smile and a claim of innovation in risk management. One of the more egregious examples of this was the advent of asset-backed structured products. With the help of sophisticated mathematical risk models, banks could convince credit ratings agencies that a pool of riskier loans, if purchased through structured derivatives, could theoretically be shown to have lower risk in aggregate, low enough in fact to be assigned investment grade credit ratings.1
There are many short duration mutual funds which invest solely in investment grade securities, so many in fact that Morningstar has an entire category just for them. Those with the highest income tend to invest heavily in mortgage-backed securities (MBS) and other asset-backed securities (ABS). It is no secret why these funds tend to outperform their investment grade peers who only use corporate debt. Whether intentional or not, these portfolios are effectively able to use structured products to get paid for taking risks in excess of what would normally be considered investment grade. But due to the aggregate portfolio risk models (which assume a certain level of diversification and duration), they can do so through instruments that have investment grade ratings. Pretty neat, huh?
We are not trying to make a case that all mortgage products are bad, and we are not even arguing that investors have been misled to invest in funds which use these products. But if we dive deeper into the models used to justify the investment grade ratings, we realize they are dependent on a handful of factors. Among those are correlation of mortgage defaults; the value recovered by the lenders during a foreclosure process; and the rate at which borrowers tend to prepay their loans. If we learned anything during the 2008 financial crisis, it was that pools of mortgages on houses from the same market tend to be much more highly correlated than is typically assumed by these models. Furthermore, for any given foreclosure, the higher default correlation results in much lower recovery values as there are typically few buyers in a housing market crash.
In our view, though, the biggest risk to these securities in the current market is that investors may be taking on more duration risk than they think. Mortgage borrowers have a tendency to prepay their mortgages, either when they sell their homes or when they choose to refinance. The rate of prepayments directly impacts the average duration of a mortgage pool – the higher the prepayment rate, the more loans get paid before their maturity and the lower the duration.
The long stretch of low interest rates we have just experienced saw a wave of refinancings that is unlikely to be replicated and may cause prepayments to be lower than expected for years to come. An upward trending rate environment would also deter homeowners from refinancing their mortgages even if they hadn’t done so recently. In addition, any hiccup in the economy or a drop in housing purchases (as some predict may happen due to recent tax law changes) would further reduce prepayments. All of these risks point to a duration extension in the average mortgage pool.
To be fair, experienced mortgage traders monitor these factors constantly and are skilled at choosing the securities which are least susceptible to these risks. But that’s just the point, isn’t it? The value here comes not from the obfuscation of a risky asset by hiding it in an asset that appears less risky. The value here comes from the careful selection of fundamentally strong loans. While we find it difficult to imagine making such evaluations based on aggregate metrics (e.g. average FICO scores or average prepayment rates), we don’t doubt there are those who can. And we have no doubt that they can find value and opportunity even among those borrowers that have been labeled as risky.2
Put another way, it’s the in-depth evaluation of individual borrowers that mitigates the default risk, not the designation of some credit rating agency. It is our experience that the more directly an investor can isolate this effort as the driving force behind a credit-oriented portfolio, the more confident he can be that the risk he is trying to take is in fact the risk he is getting.
Where does this leave investors? For those seeking capital preservation in fixed income, understanding risks is the first step. Investors can aim to find managers consistently fundamentally- focused with a straightforward portfolio of long-only corporate credit, be it bonds or loans. In our view, if there is a high degree of confidence a company can repay the short-term debt, then why not buy and hold it?
At Zeo, we do not hold steadfast to the outdated conventional wisdoms prevalent in the fixed income markets. We don’t consider deviations from common fixed income indices to be a flaw. We prioritize consistency, simplicity and transparency in how managers represent both their portfolios and their businesses. In doing so, we may be an exception to more than a few prevailing assumptions about fixed income investing. And there’s no place we’d rather be.
1 The math and modeling behind this is beyond the scope of this letter. Suffice it to say here that the risk reduction is dependent on certain assumptions of the correlation of defaults and other characteristics of the underlying pool of loans. Where the models, and the ratings that depend on them, fail is if actual observed correlations exceed those used in the models (which are typically taken from historical levels). A textbook example of this failure would be mortgage-backed derivative securities during the 2008 financial crisis.
2 This argument is not restricted to mortgage-backed securities. The same is true of more subtle complacency as well. An over-reliance on credit ratings agencies in general leads investors to have a strong bias toward longer-duration portfolios which are highly rated while vilifying credit risk as “bad”. In truth, investors who have this bias may not be de-risking but rather simply trading one risk (credit) for another (duration). We believe it’s harder to determine the direction of interest rates than it is to determine the creditworthiness of a borrower, but both exposures require some level of skill to evaluate and manage. The challenge we are setting forth is for investors and managers to be honest and transparent about the risks they are taking and how they manage them, rather than highlighting the risk they are reducing and hiding (intentionally or not) a different risk they are taking instead.
Important Disclosure Information
Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
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