Sometimes the best investment ideas are the ones that take you outside of your comfort zone.
In July of 2015, I took a call from a sales guy, from whom we had previously bought a US equity manager, pitching an idea for a soon-to-be-launched fund investing in US Mortgage-Backed Securities (MBS). Not any old MBS mind you, but some were the very ones that had been at the epicentre of the credit crisis.
Unsurprisingly, like any asset manager who came through 2008/9 with some scar tissue from exposure to structured credit, my immediate reaction to the suggestion that we re-visit the scene of that particular beating was not a positive one. BIG understatement! In fact, as scenes from “The Big Short” and visions of the investment equivalent of a toxic waste dump flashed before my eyes, I’m pretty sure I flinched and my blood pressure ticked up a couple of notches.
The more I listened, however, the more the fund made sense. And when the sales guy told me that nine out of every ten calls he made to asset managers like us lasted less than a couple of minutes and didn’t get past the introduction, I was even more interested.
By way of background, “Alt A” MBS are bonds that, for one of a number of possible reasons, have lost their original credit rating. In the post-crisis era, 85% of the MBS originated by non-government issuers between 2003 and 2007 (90% of which were initially rated AAA), had been downgraded below the BBB investment grade (IG) threshold. For most market participants, that means they’re un-investable.
But not all Alt A MBS are the same. In certain circumstances, for example, a bond that has seen just one among its 2000 underlying mortgages go into negative equity, or missed/deferred even one monthly payment, could have suffered the same fate as another with 200 defaults and a 30% delinquency rate. Importantly, despite a strong recovery in the US housing market and every underlying borrower within that MBS having continued to service their mortgages (some may even have repaid early and in full), it remained off most investors’ radar.
For an informed and well-resourced specialist manager, therefore, that lack of discrimination between “bad” MBSs made for a highly inefficient market and a correspondingly compelling opportunity.
Indeed, such was the lack of interest in the Alt A MBS market that it was not only possible to purchase one senior secured bond with a 5%+ maturity yield at a double-digit discount to par, you could soon buy a fund that owned hundreds of them. That fund’s portfolio had solid asset backing and, thanks to a sizeable floating rate component, a low duration, with no meaningful correlation to the broad fixed income market. In short, based on a bearish house view of fixed income markets’ prospects over the long term, pretty much everything we were looking for in a bond fund. To make it more interesting, the fund’s management team (all ex-mortgage originators – a classic “poacher turned gamekeeper” situation) had established proof of concept by running a $4 billion US mutual fund since 2011.
Happily, having initially expressed equal, or in some instances more, scepticism at the idea (those scars again!), my colleagues on the MitonOptimal investment committee were as enthused by the new fund proposition as I. After undergoing full due diligence, it was added to our preferred list and we invested on its launch in Dublin UCITS form. So has it been worth taking that walk on the wild side? Well, yes – to date, it’s proved to be an excellent performer, delivering market-beating returns in absolute, relative and especially risk-adjusted terms, with the prospect of more to come.