Some years ago, I along with several others had the privilege of meeting a successful value investor. As he discussed his current portfolio, some of us expressed reservations about a few of his holdings. He engaged us for a while, but then he held up his hand and said:
“Look, I’m a value investor. If you don’t question a few of my ideas, I’m not doing my job.”
A low price or high yield means a lack of enthusiastic buyers, for some reason. Often that reason is a good one. However, there are three ways the bond market presents value opportunities for us:
1) Purge: Fixed income investors often generalize specific headline risks, shedding everything that even vaguely resembles trouble, resulting in sweeping, thematic opportunities across entire sectors. They sell because prices are going down, creating a vicious cycle.
2) Pigeonhole: Investor guidelines are often defined by ratings, issue sizes and security types, all of which ignore solid fundamental analysis. Investors may simply exclude opportunities based on guideline limitations, and may neglect off-the-run opportunities due to unfamiliarity.
3) Panic: Investors may magnify survivable or transient problems into a solvency threat, overestimating the long-term credit impact of corporate transitions or short-term industry events.
The European Union Crisis of 2011 was a good example of a Purge. Investors beat a broad retreat from (global) bank credits and European corporate credits. We even heard of some large investors simply re-writing their guidelines to exclude all European issuers. From our perspective it was unnecessary to predict the success of EU and ECB rescue measures to find investment opportunities. We found several financial sector investments that a) operated within a strong sovereign and b) were well-capitalized to weather a break-up. Beyond banks, many other financial credits subsequently traded at wide spreads based on fears of persistently low rates (P&C Insurers) and a potential lack of refinancing (REITS). Subsequently, energy companies in general have offered wide spreads based on oil price volatility and concerns about emerging markets in early 2013.
Unfortunately, the bank sector opportunity is over, as you can see by the small remaining exposure in our client portfolios. We’ve been net sellers of insurance and Real Estate Investment Trusts (REITS) over the last few months, and the energy sector opportunities are drying up as well.
We saw a similar emergence of valuation opportunities in structured credit — particularly Commercial Mortgage Backed Securities (CMBS) — where a sudden uptick in rates in May-June 2013 and the anticipation of a pending refinancing wave from 2014 to 2017 brought a glut of supply and pushed spreads higher. Once again, we were able to find many, highly durable, investments offering excess compensation during this period. Unfortunately, these opportunities have also become a lot less compelling in 2014.
More recently, loan funds have been seeing outflows, leading to more attractive pricing than for bonds of the same issuer. We recently purchased two loans that offer both higher yields and a more senior spot in the capital structure than the bonds of the same issuer. The simple solution to this apparent conundrum is that loans are easily refinanced, so they rarely appreciate more than a dollar or two above par. Bonds may appreciate as long as the market rallies. Investors preferring a bad value in bonds are betting a rich asset will get even richer. Commonly known as the “Greater Fool Theory”, this is the mirror image of a Purge.
Given the huge appetite for yield in today’s market, it is no surprise that we can’t identify much in the way of large sector opportunities right now. We face markets that are, by and large, embracing risk and are therefore fully priced. Happily, investors are still redlining a few individual names for non-fundamental reasons (Pigeonhole) and are over-reacting to bad news (Panic). The vast majority of our recent purchases have fallen into these categories.
Most of our new Corporate positions over the last 6 months, and the lion’s share of our Corporate exposure overall, are in the more volatile BBB/BB space. This is a sensitive ratings zone where concerns about rating direction often cause overreaction and forced selling, and small improvements in credit quality can cause huge decreases in spread. REITs, Oil-Field Services, and Banks are still our biggest sector exposures, but they amount to only about 5%, 3.4% and 2% of the portfolio, respectively. Many names mentioned in previous quarters are gone, sold for valuation reasons. Overall Corporate exposure is down about 1.5% in the second quarter.
In Municipal bonds as well, the days of the Meredith Whitney Purge are far in the past. Yet large Municipal investors mostly seem to order the same flavor for their portfolios — vanilla. With some persistent searching, we have found plenty of specific Pigeonhole-type exposures that continue to offer value, and take up about 12% of our least constrained accounts. We still hold long, high-yielding “Build America Bonds”, but we have also been able to obtain good corporate exposure, through Industrial Revenue Bonds and Prepaid Gas Bonds, at much higher yields than conventional corporate paper. Finally, we are still holding many of our Auction Rate Securities, with the expectation of substantial gains as the prospect of higher LIBOR rates comes clearly into view. Several issuers have refinanced already.
CMBS make up about 17% of our least constrained Core portfolios. We purchased the majority of this in the supply glut over year end, only picking up an additional 2% in the second quarter. They have subsequently become the best performers among our spread product. Given the rapid decrease in CMBS spreads in the second quarter, we expect our purchases here to slow as well. The majority of our exposure is in large single or multiple property transactions with very strong hotel, retail or office tenants. We’ve also purchased intermediate tranches in a few well-seasoned “conduit” (diversified) CMBS where we see opportunities for price improvements as loans in the pool begin to refinance.
Asset-Backed Securities (ABS) are our biggest exposure area after Corporates, at more than 25% of the portfolio. Here again, we gravitate towards off-the-run issues and collateral that is neglected by many other buyers. Examples of recent purchases include a bond secured by a broad portfolio of drug patents, a capital relief securitization of investment assets by a mutual insurance company, a first securitization by a consumer lender with a one hundred year track record and a note backed by a revolving trust of hedged commodity warehouse receipts. In all cases, we retain our criteria of ample credit enhancement, a strong and experienced origination team, and clear alignment of interests with the owners/originators of the collateral.
We are well into the fourth year of finding little value in Agency Mortgage-Backed Securities (MBS). For several years now, our valuation tools have consistently pointed us away from MBS which have offered little margin of safety. We have used that space in the portfolio for additional valuable ABS and Municipal exposure, and this has been far more rewarding for clients.
While we don’t incorporate macroeconomic forecasting into our portfolio choices, we do keep an eye on macroeconomic risks that might create the “Purge”-type opportunities that have been so rewarding over the last few years. At the moment, there is more trouble in sovereign credits than in the private sector. We see diverse positive commercial indicators, such as increased hotel occupancy, tight aircraft demand, reduced CMBS loan delinquencies, and even increased PC and server sales. Credit losses are coming from places we have never had exposure, such as Argentina, Ukraine and Venezuela. More importantly, there are also very large losses to Municipal Bond funds unfolding in Puerto Rico and Detroit. Thus far, Municipal investors are taking the latter in stride, but, at the risk of seeming ghoulish, we are well-prepared should the next purge come in that sector.
We are always on the lookout for opportunities other investors spurn too hastily, whether they are hidden in some remote backwater or coming in over the Transom. If there weren’t a few things in our portfolio that cause our clients to raise their eyebrows, at least initially, we wouldn’t be doing our job.
Andrew P. Hofer
Head of Taxable Portfolio Management
For informational purposes only.