In the aftermath of the financial crisis, structured credit hedge funds have largely taken a backseat to quantitative and equities-focused hedge funds, amid the evolution of computerized trading and global economic expansion.
The bi-annual Billion Dollar Club survey conducted by Absolute Return in 2018 shows that big quant names like Bridgewater Associates, Renaissance Technologies and Two Sigma Investments have ballooned in size, while inflows for structured product specialists have been relatively muted.
But as the year ended and volatility returned to the market in the final quarter, structured credit hedge funds managed to weather the storm much better than their peers.
The Absolute Return Mortgage Backed Securities Index was up 4.66% in 2018, one of the database’s top performing strategies of the year. By contrast, the Absolute Return Global Equity and US Equity indices both finished the year in the red, declining by 3.41% and 4.55% respectively.
A large swath of the hedge fund crowd was blindsided by rising interest rates and geopolitical uncertainties stemming from the US-China trade war, culminating in one of the worst years for alternative managers.
“It is a function of the MBS space that our market typically trades with low correlation to risk assets,” said Greg Parsons, chief executive officer of Semper Capital Management. “The fundamental credit dynamic of mortgage collateral remains extremely robust.”
The Semper MIDAS fund, which is focused on non-agency residential mortgage backed securities – bonds backed by mortgage loans that are not guaranteed by government agencies – ended the year up 8.25%, according to Absolute Return data.
Semper invests in bonds issued before the financial crisis as well as next generation MBS, according to Parsons. Legacy assets became a popular trade after the 2008 financial crash: after initially trading at deep discounts, they posted big gains as house prices recovered.
Structured credit managers have been active in forbearance recoveries from legacy mortgages. Under a forbearance agreement, banks can suspend mortgage payments for a specific period of time, allowing the borrower to catch up on payments when their financial situation improves.
“A lot of financial engines interpreted forbearance as a write-down, but fast forward eight or nine years when the housing market is stronger, those dollars are being recaptured and in certain cases payments are trickling back,” he said.
Still, legacy mortgage bonds are harder to come by as borrowers have repaid, refinanced or defaulted on their debt. The eye-watering gains seen immediately after the financial crisis are long gone and managers have had to manage expectations.
Structured Portfolio Management’s Nicolas Vassalli told attendees at the 2017 SALT Conference in Las Vegas to expect more modest returns from mortgage-focused funds. The firm delivered some of its highest investment returns in the aftermath of the financial crisis, but announced it was closing its main fund in the summer of 2018.
SPM’s main vehicle – its Structured Servicing Holding Master Fund – posted an envy-inducing 134.59% gain in 2009 and continued to deliver double-digit returns for three consecutive years. But the firm struggled to maintain that pace as opportunities in distressed mortgages become more difficult to capture: the same fund gained 0.19% in 2016 and 10.22% in 2017.
“This trade was so strong between 2009-2014 that expectations about the ease of making money probably got ahead of itself,” says Parsons. “There is definitely a headwind of investor perception because the beta trade is over, now it’s more about security selection.”
Mortgage bond investors must manage duration risk in a rising rate environment, as borrowers put the brakes on mortgage prepayments to avoid refinancing their existing mortgage at higher rates.
“Right now, we are fairly heavily weighted toward floating rate assets [and] we are focused on limiting duration,” said Parsons. “If you’re buying fixed rate mortgage paper there can be a pretty dramatic rate impact.”
Parsons said a risk off trade started in late September led to price weakness on a mark-to-market basis as some investors were forced to sell bonds. “But the noise was happening against the backdrop of good fundamentals,” he said.
The risks associated with structured products are largely judged to have dissipated as lending standards have improved.
“The structures that are available to us backed by mortgages and consumer credit are conservative,” said Chris Hentemann, founder and chief investment officer of 400 Capital Management. “The rating agencies retooled their models as the market started to reopen and grow, now you have conservative loan origination in a good economic environment.”
The 400 Capital Credit Opportunities Fund, which invests in several mortgage products as well as corporate credit and consumer loans, posted an 7.07% gain last year.
While 400 Capital’s exposure is weighted towards the US mortgage market, Hentemann sees opportunities emerging in corporate credit. Approximately 15% of the fund’s capital is allocated to collateralized debt obligations and high yield corporate credit, according to an investor letter seen by Absolute Return.
“The CLO market outperformed through the financial crisis relative to consumer credit and many investors were underinvested at the time,” says Hentemann. “Today we feel the market is crowded and overdone, but we remain opportunistic investors when it gets vulnerable.”
CLO’s are more sensitive to movements in equity markets because they are backed by pools of corporate debt. The Securitized Products Fund previously managed by Credit Suisse Asset Management said CLOs were among the poorest performers at the end of last year.
“CLOs was the worst performing subsector within structured products, as heavy supply combined with growing concerns about corporate credit pushed spreads wider across the capital stack,” the firm wrote in a November letter to investors.
The more than $2 billion SPF, which spun out of CSAM at the end of last year, posted a 6.35% return in 2018 having had only one down month in December, according to performance data seen by Absolute Return.
The burgeoning CLO market underpinned much of the demand for corporate debt over the last decade, but investor sentiment is shifting as issuance approaches record highs. CLOs are the largest buyers of so-called leveraged loans, an asset class that is under increasing scrutiny from regulators.
Leveraged loans have become a staple of the corporate debt market since the financial crisis, finding popularity as a floating rate asset with relatively high returns in a low interest rate environment. But large financial regulators like the International Monetary Fund and the Federal Reserve have expressed concerns about the impact of the leveraged loan market on financial stability.
“With interest rates extremely low for years and with ample money flowing through the financial system, yield-hungry investors are tolerating ever-higher levels of risk and betting on financial instruments that, in less speculative times, they might sensibly shun,” the international regulator wrote in November.
Seer Capital Management, a $1.1 billion securitized products fund that invests in CLOs, said high volume is weighing on CLO spreads. “We hope that CLO issuance continues to moderate, which would be constructive for CLO spreads,” the firm wrote in its September investor letter.
The Seer Capital Partners Fund posted returns of 8.83% last year, according to the investor letter.
CLO returns ended the year top of the fixed income asset class, despite weakness in the second half of the year, but industry heavyweights have warned of a brewing corporate credit crisis.
Billionaire investor Paul Tudor Jones recently warned that leverage levels in financial markets are unsustainable and rising interest rates could “stress test our whole corporate credit market for the first time”.