Presenters: Neil Hohmann
Hosts: Jack Chee, Rajat Jain, Jason Steuerwalt, Jeremy Degroot, Peter Sousa
Date: May 16, 2019
PS: Hello, everyone. This is Peter Sousa. I’m the director of portfolio strategies here at Litman Gregory. I’m filling in today for Mike Pacitto, who is out on location at the CFA Society meeting in Los Angeles. I want to thank you so much for joining us for the Second Quarter 2019 Masters Funds Quarterly Webinar.
Joining us today is the Litman Gregory Research Team — Jeremy DeGroot, Chief Investment Officer and Portfolio Manager for the Masters Alternative Strategy and High Income Alternatives Funds; Rajat Jain, Senior Analyst and Portfolio Manager for the Masters International Fund; and Jack Chee and Jason Steuerwalt — Senior Analysts and co-PMs for the Masters High Income Alternatives Fund.
Our special guest today is Dr. Neil Hohmann. Dr. Hohmann is the head of structured products and a portfolio manager for BBH Investment Management — as well as a subadvisor on the Masters High Income Alternatives Fund. We’re very excited to have Dr. Hohman with us today, and look forward to his insights.
A couple of housekeeping items before we get started. We’re going to switch up the format of today’s webinar. On the front-end of the call, Jack Chee is going to interview Dr. Hohmann, to highlight BBH’s investment strategy for their sleeve of the High Income Alternatives Fund, with a particular focus on the asset-backed securities sector, where BBH is currently identifying opportunities — and how the asset class and their strategy can improve portfolio outcomes.
We’ll then turn it over to the Litman Gregory Research Team, who will provide updates on the Masters High Income Alternatives Fund, the Alternative Strategies Fund, and the International Equity Fund.
We will be taking live questions during the webinar for both the Litman Gregory Research Team and Dr. Hohmann. So please enter your questions via the GoToWebinar console.
For those questions that we aren’t able to address today, we apologize. But the Masters Relationship Management Team will follow up. Finally, a replay of today’s webinar will be available soon on the Masters Funds website.
Without further ado, I’ll now turn it over to Jack Chee.
Jack: Hi, everyone! Thank you for your time. Yes, Pete has already introduced Neil. So I think we’re going to just jump in and get started on the process.
Neil — again — thank you for your time and being able to walk through how BBH is investing and where you’re finding opportunities right now.
Let’s start off by providing a good sense of BBH and who you are as investors. We know that the firm recently celebrated its 200-year anniversary. There are lots of — I guess I’d call them — enduring and prized aspects of your investment culture.
Can we start off by you elaborating on the overarching tenets of your approach to investing in credit?
NH: Sure, Jack.
Brown Brothers has been a lender since the very beginning — going back 200 years.
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I guess you don’t get to 200 years without being somewhat careful about your underwriting.
I’d say the fundamental underlying tenet of our credit-approach and also, I think of credit broadly at Brown Brothers, is preservation of capital.
Preservation of capital really underpins our process and our approach. It underpins our reliance on deep fundamental research. It underpins the stringency and consistent application of our credit criteria. It also explains the requirement that we have for a sufficient discount for safety margin.
A couple of other tenets —
We do invest only where we have a margin of safety. That applies both on the credit side, as we’ll talk about in a moment, and also on the valuation side.
I think another thing that differentiates us a little bit as a manager is, we take a very long-term approach to valuation. You’ll hear me speak of us as the Quarter-Century Club.
You’ll hear me talk about how we look backward 25 years at long-term average spread-level for different sectors, for different ratings and different bond-tenors. We look back that far to look at price-volatility in the same context.
That’s how we evaluate value; in a long-term context.
I think it’s really important to stress, though, that the focus on capital preservation is not inconsistent with generating attractive returns. In fact, I think our experience would suggest the opposite.
There’s one fundamental tenet — one observation — that we’ve made about credit markets in fixed-income that drives our approach. That’s that the compensation that we see available in credit markets is often disconnected and can fluctuate wildly away from the credit fundamentals. That can come from several sources.
One common source on the corporate side is you see a lot of noise in expected ratings changes. You see a lot of headlines associated with earnings or an industry development. It’s just been our observation that those types of events can move spreads. They can move compensation far more than any sort of observed change in the financial strength of the company. Or of a structured security.
We also see dislocations that aren’t so much ephemeral. We also see dislocations that are rather persistent in certain markets. These are a little bit different.
Rather than deriving from an individual event, we’ll see consistent supply/demand imbalances. We’ll see a sector where investors for one reason or another aren’t that familiar with the securities. Or there’s a smaller number of investors. Maybe it’s out of index.
You’ll see that, for example, and we’ll talk about this today, in the asset-backed market. There’s a narrower range of investors.
But we also see opportunities in — let’s say — less-familiar sectors of the market. For example, investment-grade loans. We see it in other corporate sectors, too.
We’ve tried to maintain a pretty simple strategy to exploit dislocation. If we’re trying to exploit dislocations relative to fundamentals, the first thing we need to ensure is that we have a really good handle on credit fundamentals. That’s where our credit-criteria and our concept of a safety margin on the credit side really comes in handy. We also believe in looking deeply into credit.
We’re a medium-sized manager. We manage $60 billion in assets altogether. We manage about $35 billion in fixed-income. We have 16 analysts looking at bonds and loans for the team.
That’s the fundamental credit-research. It’s very important to us.
Then second — we need to figure out where or just how to define a dislocation. Our rigorous valuation approach, which we’ll talk about, tells us when we should be buying securities. When there’s a large-enough dislocation that we see value.
JC: In terms of your mandate, you have a lot of flexibility to invest across the asset classes, and implement that whole philosophy you just described.
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But can you talk about the primary opportunity set in terms of where you’re getting most of your ideas?
NH: Yes. We’re fortunate in being a medium-sized asset-manager. We can really make effective use of $200 million or $500 million transactions. We are finding value, generally, broadly across credit. Across different corporate sectors in the structured market. Occasionally, even in the muni market on a taxable basis.
But not surprisingly, our size allows us to find value in some consistently highly-compensating quarters of the market. We’ll talk about that a little bit today.
One of the most prominent is ABS. We’re about 30% ABS in the Masters High Income Sleeve that we manage. Consistently, it makes up anywhere between 30% to 50% of our mandate for the supply/demand technical reasons. There’s consistently value in that sector. It very much meets our stringent credit requirements.
We also tend to find value in CMBS. The value we see in commercial mortgage-backed securities can fluctuate a little bit more. The advantages — the compensation we see there — isn’t quite as persistent as it is in the ABS market.
We focus on a segment of the CMBS market. Single-asset; single-borrower transactions. These are deals that are secured by — rather than the more-familiar conduit of CMBS deals, which are 80-100 loans across different property sectors — the single-asset; single-borrower segment of CMBS, which has grown in size recently focuses on a single loan on a single property or portfolio of properties. It tends to be a single type of property.
What we really like is they’re high-quality properties. Offices in New York City, portfolios with great retail sponsors like Simon Properties. They’re high-quality portfolios, and the rating agencies place an alarmingly — from their perspective — low amount of leverage on these deals.
So you can participate at what we see as very-low-leverage levels. Very positive credit-wise. 30-40% leverage on the appraised value of a deal. Just because of rating-agency caution in that sector.
We’re finding a little bit less value there today, just because of compensation shifts. But that’s an important part of the portfolio.
On the corporate side, a couple of sectors where we’ve typically seen value — business-development corporations. BDCs. A lot of equity-investors think of BDCs more like a 4-letter word. Just because of the some of the reputation in terms of fees, there.
But from a debt standpoint, you’re essentially holding unsecured-debt that represents — together with secured-debt — only 30-40% debt-to-assets on a pretty high-quality portfolio of direct loans. So, comparable to a triple-B-rated CLO, where you’d hold 85% debt-to-assets, it’s a really nice arbitrage.
You can invest in five-year triple-B-rated paper today at 300-bps over treasuries. So for this sleeve and across the board for our accounts, we’ve found a lot of value in the BDC sector.
Similarly in the insurance sector on the corporate side, there are smaller names. There are more specialized names. More geographically localized names. Where the surplus is quite ample.
These insurance companies have long historical tenors. They’re quality credit. But they may only have one issue outstanding. Or they may have a relatively small amount of debt-outstanding and can offer significant benefits there.
On the loan side, investment-grade loans are a segment that we see a decent amount of value in. Often, CLOs [in funds] are looking for high-yield loans. There’s relatively little demand for loans in investment-grade companies. We can often invest at spreads at-or-above unsecured-bond levels on the loan side, and we get the security. So, investment-grade loans are another important segment where we find value.
Just to round things off, you’ll see some power-project loans in the Masters High Income Sleeve. These, like single-asset; single-borrower, the rating-agencies give a specially-favorable treatment to, because they’re more concerned about the lack of diversity. We’re more impressed with the high-quality nature of the demographic areas that these plants are in.
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The fact is there’s very little sensitivity to rate and volume-shift — because most of the revenue comes from fixed-capacity payments — and the leverage is reasonable on these deals, and typically declining. You get paid margins anywhere between 400-500 bps for these types of opportunities.
Jack, sorry to take a little bit of time, but that hopefully gives you a sense of some of the parts of the market where we’re seeing value.
JC: Yes. Let’s kind of switch gears and talk about as you’re doing your bottom-up fundamental analysis or the four key-criteria that you look for.
As we’ve gotten to know you guys over a lot of time, a cornerstone to us seems to be durability. I’m bringing that up because we talk to a lot of credit investors. Our take is that what you and the team — what you and the guys — require around the credit’s durability is probably among the most-demanding that we’ve come across.
Thinking maybe we can dig into the durability and talk about how you define and measure that, and what scenarios a credit has to stand up to, to qualify for a spot in the portfolio.
NH: Yes, Jack, I think that’s a really good observation.
Durability is really important to us. Just to give you a definition, we define it as the ability of a bond or loan to withstand the widest range of economic conditions.
You’re right. I think that differentiates us from some other managers that may be willing to take a bet or invest in securities somewhat dependent of where we are in the economic cycle.
We don’t see ourselves as macroeconomic forecasters. We really try to take macroeconomic conditions out of the picture.
If you think about it, if you can buy a bond at a significant discount and then hold it to par payment at maturity, you’ll earn that discount.
The catch there, of course, is you have to be comfortable holding the bond to maturity. If you think about that definition of durability, if we pre-stress bonds to the worst conditions that we can anticipate in a given industry, or in the macroeconomic level, then it’s going to give us that comfort as more-adverse conditions occur. Holding that bond to maturity and earning that discount.
I’ll just give you a couple of examples.
In 2014, we were pre-stressing. Our corporate analysts were pre-stressing our energy and mining holdings to a 50% decline in energy prices and commodity prices. It’s quite severe, but it is in line with declines that we’ve seen in the past.
It wasn’t a lot of fun in ’15 and ’16 when we saw prices decline as much as they did. But we were pretty comfortable holding those securities through that period, having only chosen companies with less leverage and stronger cashflow attributes that could weather that type of downturn.
We didn’t own some of the more-levered names in the sector, many of which ultimately defaulted and resulted in losses to investors. Because we restricted ourselves from buying that more-levered segment of the market that wouldn’t hold up to that stress.
On the ABS side, we’ll get into a little more detail on the stresses. But the types of stresses that we put in place are quite stringent.
One of the stresses we put in place is that any bond we invest in has to hold up to economic conditions reminiscent of the Great Depression. So, 25% unemployment levels.
That helps us be comfortable investing across a broad range of different subsectors in the ABS market. It does keep us out, occasionally, of some more-levered credits and some lower tranches than the structured market that may offer more compensation. But we feel very comfortable holding those securities through tough industry and economic conditions.
JC: Do you want to touch on — just for time’s sake moving on — to some of the other criteria? How it’s sort of applied across different asset classes. Obviously, a muni bond is going to have —
You’ll have different aspects to it that don’t apply to corporates or structured. Can you just touch on that?
NH: Sure. On the management slide — if you turn to Slide 8, I think you can see these criteria. On the management side, we really look for an experienced team. We like to see a couple of decades working together.
We like a management team that balances the need of lenders with the equity-holders.
Strong execution over time. Interestingly, management’s really important for structured credits, as well. It’s your first line of defense.
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I think we feel more comfortable having seen management teams that have managed underwriting loans and leases through severe instances in their industries, such as ’07 and ’08 — or in the aviation industry in 9/11. That is very encouraging to us, when we can see that demonstrated performance through a downturn.
Proper structure is important, too. That’s pretty straightforward. We want to see the appropriate leverage for a particular industry on the corporate side. We want to see maintenance of good liquidity.
Where applicable on the corporate side, we want to see a demonstrated security interest and the appropriate covenant.
On the ABS side, we’ll talk about this. We like to see skin in the game. We like to see that the originator of the loan or lease collateral has incentives aligned with ours and have sizable equity beneath our debt. And that there are some good performance triggers in the deals that protect us in the event that performance goes sideways.
Finally, transparency is also a cornerstone. This is, I think, a little bit under-appreciated perhaps by different investors. But management’s reputation for accuracy. Our being able to get appropriate access to financials.
Transparent business structure. Something that’s not really complicated. We’ve never gotten that comfortable, for example, with GE. Just because of the complexity of that company. Those are all very important on the corporate side.
On the ABS side, those corporate transparency requirements are supplemented by our ability to look at the underlying collateral in detail. By sufficient monthly reporting. And maybe surprisingly we get great access to the CEO — to the C-suite. The CEO and CFO of all of the 160 or so originators that we know well.
That’s important for us to have that kind of management access.
JC: Yes.
NH: It’s interesting. Sometimes on the muni side, you kind of scratch your head. But seeing a controller that doesn’t seem to know what they’re about is a warning sign for us. Poor management on the muni side, even though there’s recourse back to a taxing authority, can be a red flag, as well.
JC: I want to just jump onto valuation really quick. I think you guys have an interesting approach where you can apply a pretty consistent framework that underpins all of your purchases. I thought that definitely was worth touching on.
And I definitely want to save some time for the ABS section. So I might ask you to just give a brief overview of the valuation. Then maybe we can come back in the Q&A.
NH: Valuation is really important. You do well by investing at a discount and holding to par. But you can only do that if you can define what a “good discount,” is.
Over the last decade, we implemented a pretty broad valuation framework that we can use to compare, for example, an agency MBS to a corporate or to a muni.
We run this framework weekly on the index. That’s about 8,000 bonds. Our quant team does this.
Really, the basics are just that we want to look at valuations on a long-term historical perspective. 25 years of average spread and volatility. We want to recognize that bonds mean-revert in spread. We want to recognize possible price-appreciation and depreciation over a one-year period. And we want to compare bonds on their expected one-year return over treasuries.
After all that, we require a sufficient safety-margin in the discount to buy. In order to do this, for any given bond, we’re looking on the positive side at its carry and expected price-increase or decline, based on whether the current spread is above or below our long-term estimate of spread. We’re subtracting out any optionality costs — any credit costs. Any liquidity costs.
Then that spread, with that expected excess-return equal to zero, is the “sell” level. That first dotted line on Figure 9. That’s the level at which we will not —
Any spread higher that, we won’t own the bond. But we also ask for that safety margin. We require that safety margin. The size of that safety margin, which is indicated by the second dotted line — we need that additional spread-incriminate and excess-return increment in order to buy the bond.
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That will depend on the historical price-volatility of the bond.
If that particular type of security has experienced more price-volatility historically, then we need to be compensated for that. That’s how we establish what we want to buy into the portfolio, and what we want to sell.
Any spread-level to the right of that second dotted line will represent a buy opportunity. Between the two dotted lines, it’s something we’d hold in the portfolio and reduce in size, as spreads tighten. Then left of the first dotted line is a bond we’d sell.
JC: I’m actually going to, for time’s sake, skip ahead Neil — if that’s okay — and jump to the ABS section on Page 14. We’ll start off that aspect talking about an overview of the opportunity set in this non-traditional ABS space.
I think what’s interesting most is that it’s often called non-traditional ABS. But I think the lion’s share of issuance these days is actually in this segment of the market — within the ABS market. Maybe it’s a bit of a misnomer, anymore.
NH: Yes. You’re absolutely right.
The rapid growth of ABS issuance in the last decade really has its roots in the retreat of lending by banks during the financial crisis. That pullback has led a lot of long-established manufacturers and finance companies to diversify their sources of borrowing.
Increasingly, medium-to-large-sized companies issue asset-backed securities in the capital market to supplement their bank lines, so they’ve less dependable than they used to be.
We often talk with the CEOs of these ABS issuers that we know well, and pretty much — to a T — they tell us universally that diversifying their borrowing between the banks and now the capital markets is simply a risk-management best-practice today.
Their shareholders demand it.
Before the crisis, you might see the first top two firms in an industry issue ABS. Today it’s the top 5 or 6 leaders in the industry that issue ABS to diversify their borrowing.
You’re right — we’ve seen a really expanding and maturing market for what nominally we’d call non-traditional ABS products. Today it’s really a half-trillion-dollar diversified asset class. It continues to grow, and it’s composed of more than 30 different subsectors, where we find a lot of attractively priced opportunities.
You can just see them really quick on these two pie charts. The blue represents the more-traditional credit card and prime-auto sectors. You can see that in 2018, those dominated issuance. It’s the opposite today. It’s all the other subsectors in the ABS market that really compose the bulk of issuance.
You can see also that that’s resulted in tremendous growth in the non-traditional segment.
JC: Part of the reason we wanted exposure to this space — specifically, you and the team’s expertise there — is that this area actually generates relatively attractive spreads when you compare them to other similarly-rated corporates, for example, or traditional ABS.
Could you just walk through that and shed some more light on that area about the more-attractive returns?
NH: Yes. You can get a pretty good sense on Slide 15, I think. Because of these supply/demand imbalances — there are only 15 to 30 insurance companies or about 15 to 30 money managers that invest in these securities. We’ve seen how quickly they’re growing.
You get a real sizable list over comparable-duration in rated corporates. And even traditional ABS. We typically are investing, for the Masters High Income sleeve, occasionally even in triple-A issues, at spreads between 75-bps to 250-bps over treasuries.
At the single-A rating-level, where we’re probably more commonly investing for the fund, we’re investing anywhere between 275-bps to 450-bps over treasuries. You can see relative to the green dots and red dots on that chart that that’s quite a sizable pick-up.
JC: With the sizable pick-up, I think often people will just have to wonder. Like, “Well, am I taking on more credit-risk?” Or, “Am I giving up some liquidity?” There’s no free lunch. So, what actual risk am I taking to get that premium yield?
I might just actually turn it over to you for a while and let you walk through some of those aspects of this part of the fixed-income market.
NH: Yes. I appreciate it, Jack. We get that often. It’s a large part of the portfolios we manage, and we call it the, “Too good to be true,” question.
I think it really does come back to the fact that you have some barriers to entry into the ABS sector that we can talk about, coupled with some pretty sizable growth for the secular reasons that we outlined.
Credit is actually a real strength of the ABS sector.
If you look at Slide 16, historically, ABS bonds show good ratings-stability and low losses during even the most-severe economic downturn. We look at the financial crisis of 2018, which is the worst US economic downturn since the Great Depression, and we think it offers a pretty good test of the strength of credit in ABS.
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If you look at rating-agency data and track the cumulative impairment-rate of different sectors, both through and following the crisis — when you take all of the ABS investment-grade, ABS-outstanding at the end of 2007 — that’s about $800 billion of debt. You simply follow those bonds’ performance forward through the crisis into present. There’s only one ABS security that’s experienced any impairment out of the thousands that were issued. That translates into a very low impairment rate, as you can see, of only 0.02%.
In contrast, if you look at impairment-rates just for investment-grade corporates or high-yield corporates — you can do the same exercise. Look at everything that was outstanding at the end of 2007 for those two sectors. The impairment rates are somewhat higher — 1.5% and maybe not surprisingly in high-yield, cumulative impairment rate’s been 21%.
So, comparative credit-performance for ABS historically has been strong.
I think that credit-strength is reassuring to us, but we also want to apply our own criteria to make sure that the bonds we’re buying have that safety margin in place.
Even though the bonds that we invest in have anywhere between 20% to 40% enhancement underneath them — that consists of subordinate debt and the equity of the issuer — every note that BBH purchases must withstand some quantitative cashflow stresses that are pretty severe, to ensure that margin-of-safety on the credit side.
Let’s put the conservatism of our required safety-margin in a little bit of context. The US recession of 2008/2009 was our most-severe since the Great Depression. The impact on ABS collateral — the loans and leases that underlie those deals — was actually pretty moderate. We saw loan and lease losses temporarily rise anywhere between 30% to 100%, depending on the product. Then they’d settle down within a year, back toward historical lows.
Actually most ABS issuers, because the loss-performance was relatively modest, remained quite profitable during this episode. We require notes to tolerate a far more severe scenario. Every ABS note that we purchase has to withstand a cashflow stress in which collateral losses rise permanently to 250% of our base-case loss-projection. That’s many multiples of that 30% to 100% that we saw in the last recession.
Like I said — in addition to that 250% stress, we also require that our notes can withstand something on the order of the Great Depression. A 25% level of unemployment without any impairment of principal or interest.
There’s a similarly high hurdle for our CMBS investments. There, we require that they maintain a 65% loan-to-value maturity, even after we’ve stressed the valuations in the most-severe recession scenario.
Our stress levels are set not just to ensure a low probability of loss from the bonds that we buy, but really to ensure a negligible probability of loss on the bonds we bought. I think it helps explain why over the last decade we’ve only actually only had four bonds that even experienced a downgrade by queuing to these types of stringent criteria.
The quantitative stresses, though, are only part of our approach. I think we’re a little bit differentiated as a manager, because we pay special attention to the qualitative strengths of our originators. I think the qualitative strengths of ABS originators are pretty apparent across the ABS-issuance universe. It helps explain why the credit-performance was so good in 2008 and 2009.
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ABS generally is secured by loan and lease collateral that’s been time-tested through a lot of credit cycles. For example, GMAC issued the first auto loan back in 1916. One Main is the current issuer of ABS. It was really 100 years ago when they literally financed stagecoaches among their earliest loans.
The trucking container fleet-leasing industry dates back to the 1940s. We only invest in ABS and CMBS that’s backed by collateral that’s weathered several business cycles.
Also, issuers of ABS — yes —
JC: I was going to say, one question that actually came in —
As you speak to collateral that has weathered business cycles, one question that just came in was, “What do you do with bonds from companies that haven’t issued a lot of debt or just don’t have much of a history in how you judge that?”
It might be worth, also, just commenting on revisiting something you touched on, which is about requiring a trough within an industry before investing.
NH: Yes. I think there are some newer industries. To your point, Jack, they get two strikes immediately.
An industry that’s new, and a company that we haven’t seen perform through a downturn — that does fail our criteria on a couple of scores. We just don’t invest in them.
It doesn’t mean that —
There are some decent-sized subsectors in the market that we don’t invest in. One example that fails the criteria is marketplace lending. There’s been a big growth in lenders like Prosper and Lending Club that will lend $35,000 online. Those models started after the financial crisis. We just don’t know how they’re going to perform when we go through the next recession. We suspect not very well.
So you’re right. Not only do we not see the time-tested performance, but we don’t see how the management team has worked together, and the consistency of underwriting through a downturn. Actually, in the case of marketplace lending, there are three strikes. Because they tend to sell their production as part of their model, to sell productions to third-party investors. That’s the marketplace segment. The marketplace component in marketplace lending. So they don’t have skin in the game, either.
That’s a sector we don’t invest in.
A couple of others — solar rooftops. That’s obviously a relatively-new sector. It’s grown, post-crisis. We don’t invest in that. There’s also the single-family rental. The purchase of distressed housing by large firms like Blackstone, that were attractive during the crisis. We think of that as more of a trade and not a long-term industry. Not time-tested.
The issuers of ABS and CMBS tend to be long-established, medium-to-large-sized manufacturers and finance companies. As I mentioned earlier, we do require issuers to be profitable and financially secure. We look for those experienced teams. We look for that transparency that I mentioned earlier. We need to have that relationship with the management team.
We’re pretty fortunate that we can pick up the phone and talk to the CEOs and CFOs and chief credit officers of all of the 160 issuers that we invest in on the ABS side. That’s how important that ABS financing is to those management teams.
Then we need that skin in the game. We need that alignment of incentives. What’s wonderful about some of the non-traditional ABS that we invest in is, we have an equity position anywhere between 10% to 30% underneath us. The rating-agencies tend to be conservative when there are only 4 or 5 issuers in a given subsector.
JC: Can I ask you just to give a really zippy overview of liquidity for this space? Just because we’re going to start leading into the rest of the call. Thanks.
NH: Yes. Liquidity is surprisingly good. That’s another explanation we hear. Liquidity must be very poor for this asset class, to explain those spread levels. It’s actually pretty good. 15-to-30-bps bid/ask spread. They’re traded over the same markets that corporates are. The same 15 dealers that you’d trade corporates — they’re traced. So you can see all the trade activity on Bloomberg.
I think one of the reasons the ABS sector is maybe a quarter of the size of the investment-grade corporate sector —
One of the reasons the liquidity is similar to medium-term corporate notes is that the capital-treatment the dealers get for holding ABS is about a fifth of the capital requirements for holding corporates.
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As we mentioned, the yields are clearly higher than the corporates. The typical dealer has a really good incentive to hold a larger inventory of ABS relative to larger inventory of corporates.
For all those reasons, plus the fact that it’s a pretty buy-and-hold stable investor base of US insurors and a few US money managers. Not a lot of non-US interest and participation in the market.
For all those reasons, the bid-ask spread volatility tends to be a little bit better than corporates during periods of turbulence. We didn’t talk about it, but we have some pretty extensive data, if anyone is interested, on one of the slides. It demonstrates that similar liquidity to investment-grade corporates.
JC: Okay.
Well I think I’m going to turn it back over to the rest of the team and let them provide their updates. Maybe if there’s time left over we can touch on a couple more aspects of this space, to wrap things up — time-permitting.
PS: Excellent. Thanks, Jack. And thank you, Dr. Hohmann, for really some great insights into BBH’s approach, and into the asset-backed security sector. Very helpful.
We’ll now pivot over to the Litman Gregory research team. Jason, I’ll start with you. We’ll go through just a couple of quick updates on the rest of the Masters Funds.
We just heard a ton of great detail from Dr. Hohmann, and on the BBH sleeve of the Masters High Income Alternatives Fund. Would you mind providing an update on the overall fund itself?
JS: Sure. Thanks, Peter.
The fund was up about 4.1% in Q1. It was up about almost 5% year-to-date through yesterday.
In Q1, the Barclays Agg was up a surprisingly strong 2.4%, and high-yield was up about 7.4% — which was its strongest quarterly performance since 2009, a year when the asset class returned over 50% as it recovered from the financial crisis.
Because the fund’s credit managers aren’t yet fully invested. So they’re also unlikely to be positioned with as much risk as the high-yield market. We’re not surprised with the trailing high-yield in this type of environment.
To reiterate our goals and expectations for the fund, we think it should be able to generate income and returns that are significantly higher than core fixed-income, and are competitive with high-yield bonds over time, with a risk-profile that falls somewhere in-between investment-grade and high-yield.
We think it should be able to achieve this, because the credit managers — as you’ve heard — have the latitude to shift between loans, bonds and structured credit. Depending on what’s most attractive. With an emphasis on less-efficient areas of the market, as you’ve heard Neil and Jack talk about. As well as vary their overall level of exposure — depending on how attractive the opportunity set is, relative to the risk.
Then as a complement to BBH and Guggenheim, Ares invests in less-efficient income-oriented alternative-equity types of securities, like BBCs, mortgage-REITs, MLPs and closed-end funds. Areas that are often pretty retail-driven, so much less efficient.
Neuberger-Berman sells collateralized out-of-the-money put-options on equity indexes. We think both of these strategies, while somewhat higher volatility, are quite attractive for income investors, and are typically absent from a lot of portfolios. Including them at a somewhat lower weighting makes a lot of sense, as part of an overall portfolio.
Naturally, we frequently get asked about the fund’s yield. So I’ll quickly go manager-by-manager, as of 3/31.
The Ares portfolio yielded almost 9%. That includes a cash position that was about 10%. BBH had a yield of almost 5%, with a duration of 1.9. Guggenheim had a yield of 3.7% with a duration of 0.4, and almost a third of the portfolio in cash.
Neuberger-Berman is a little bit trickier because of the nature of the strategy. The collateral portfolio that’s invested in treasuries yields or yielded about 2.4%, with a 1.3-year duration.
Income from selling options varies considerably, which I’ll get into briefly in a second. Overall, the fund’s official SEC yield was about 3.5%. The total distribution-yield, which we’ll be able to talk about after the fund gets through a year, is going to be somewhat more complicated than the SEC yield.
The amounts distributed from the option premiums are treated as a mix of long-term and short-term capital gains. That’s [not/all] reflected in the SEC yield.
As I mentioned, they’re going to vary significantly over time. For a little bit of context, at the beginning of the year, the annualized yield from selling one-month 3% out-of-the-money put options on the S&P 500 was about 20%. At the beginning of April, after fear went down and complacency went up, that had shrunk to about 6.4%.
The exact numbers here aren’t critical. I’m really just trying to illustrate how much it can change in a pretty short period of time. Thus, the potential distributions from that piece of the portfolio can vary quite a bit, based on investor-sentiment and the subsequent realized equity market performance.
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We also expect the income level from the flexible credit managers to increase, going forward — as BBH and especially Guggenheim continue building out their portfolios and invest somewhat more aggressively when the opportunities present themselves.
Importantly, even though this is an income-oriented fund, we don’t want the managers to chase yield at the expense of prudence and risk-management. I think you can really hear the risk-management and judgment involved when Neil talks about the process at BBH.
With all that said, we’re very satisfied with the way the subadvisors navigated the treacherous market environment we launched into in Q4 of last year. It subsequently recovered strongly this year. We are really excited about the prospects of the fund going forward.
PS: Perfect. Thank you so much, Jason. Appreciate it.
Jeremy, we’ll now turn it to you for an update on the Alternative Strategies Fund. The fund has gotten off to a very strong start to the year. Would you mind just sharing a couple of thoughts on performance so far this year? As well as the fund’s longer-term record.
JD: Yes. I’d be happy to do that.
I think that obviously since September of last year, it’s certainly been a volatile period for financial markets. Overall, I’d say we’re satisfied with how the Masters Alternative Strategies Fund has performed during this period.
As we noted in our year-end report, the fund held up very well during the sharp market selloff during the end of 2018. Just as a reminder, from its high on September 20th to its Christmas-eve low, the S&P 500 lost nearly 20%. The Masters Alternative Strategies Fund fell less than 1/5 as much during that period. It was down only 3.4%.
If we look at the period since the December 24th market low through a couple of days ago when we ran the numbers, Masters Alternative Strategies gained 5%. That captured nearly 1/3 of the upside of the S&P 500.
Looking at the entire period from the market-high on September 20th 2018 through May 13th 2019, the Alternative Strategies Fund gained 1.5% versus a loss for the S&P 500 of 2.1%. Over this volatile period, we saw beneficial negative-correlation between our Alt Fund and the stock market, and a nice positive upside/downside capture.
Looking at the fund’s longer-term numbers — since-inception, as we can see on this chart, through the end of April — actually, this is through the end of March. But going through the end of April, the fund had a 4.8% annualized return, which was almost exactly 400 bps above 3-month LIBOR over that period.
The fund’s volatility since-inception has been very low, at 3.2%. Combined with its absolute-return, these numbers compare very favorably to the fund’s comparable risk-benchmarks, which are shown in this table. Such as the Aggregate Bond Index, the Morningstar Multi-Alternative Category, and the HFRX Global Hedge Fund Index.
Masters Alternative Strategies Fund has more than doubled-or-tripled the total-returns of these benchmarks with comparable volatility.
As I mentioned, the fund rebounded nicely in the first quarter. Some of its performance was due to portfolio moves that our subadvisors made during last-year’s market-volatility. Having managers and strategies with the ability to invest opportunistically and more aggressively when markets drop and prices, yields and spreads are attractive is really a key part of the fund’s mandate. We think it’s a key element of its value-added.
Some examples from the recent market dislocations include DoubleLine, which shifted over 10 percentage points of its portfolio from a cash-holding into fixed-income sectors outside of non-agency mortgages. FPA initiated or added to positions in beaten-down financials, technology stocks and into commodity-related equity positions. Loomis Sayles opportunistically bought high-yield bonds and increased their net-allocation to high-yield from basically zero to the low-teens over the course of the fourth-quarter. Again, while high-yield was really getting hit very hard during that period, they found pricing quite attractive.
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Finally, Water Island also significantly increased its gross long and net exposures in the fourth quarter as spreads widened. At the same time, they increased their allocation to lower volatility. What they call “harder catalysts,” in merger-arbitrage positions. Managing the risk-exposure while they increase their net exposure.
All of these moves produced positive results in the first quarter. And all five subadvisors and strategies on the fund delivered positive returns in the first quarter, which ranged from 2.1% for Water Island to 10.7% for FPA, net of their management fees.
Now the flip side of this is because of the speed in magnitude of the rebound in equity and credit markets this year, the opportunity set for our managers has once again become less appealing. Given this backdrop and our subadvisors’ investment discipline and risk-management focus, I’d say they’re relatively conservatively positioned within their strategies on our fund; albeit with some pockets of opportunity where they’re still finding attractive risk-adjusted returns.
Our managers’ abilities to deploy capital into various market dislocations when they occur should produce attractive absolute-returns over time. Although these opportunities are sporadic. But by capturing more of the upside than the downside of equity and credit-market moves, adding value through sector and security selection both long and short — remaining largely neutral to the direction of interest rates — and harvesting returns from idiosyncratic corporate events — we expect the Alternative Strategies Fund to continue to generate strong risk-adjusted returns over time.
PS: Thanks, Jeremy. Appreciate it.
Certainly the fourth quarter of last year and the first quarter of this year offered some really good examples of the opportunistic nature of our managers. So thanks for going through those.
Finally, just to finish up here, we’ll now switch gears and talk about the Masters International Fund. The fund has performed very well this year; both in absolute terms and relative to its benchmark. Rajat — could you please provide a few highlights?
RJ: Sure, Peter. Happy to.
I mentioned some performance highlights in my comments. If you look at this slide, one thing that stands out is the fund’s overweight to Europe.
Just for context, according to Morningstar, the average blend [forward-length] year is also overweight to Europe. Around mid-50s. But our fund has more.
This overweighting to Europe actually was the largest contributor to relative performance in the first quarter.
There have been a lot of negative headlines related to Europe, as we all know. Some of it is warranted. But as is often the case, sentiment has become overly negative.
As a result, it offers our managers stock-specific opportunities.
One example I’d like to mention is Lloyds. It’s a UK bank. Brexit has created a lot of uncertainty about the UK’s future economic growth. However, Lloyds has a market-leading position and it will benefit when economic growth normalizes in the form of higher loan-growth versus present.
Despite the growth headwinds, Lloyds continues to manage costs extremely well. It generates around mid-teens ROE. And it recently announced larger-than-expected share repurchases. Such a high-quality bank trading at less-than book value — around 0.8 to 0.5 — is quite cheap. In fact, two of our managers, David Herro of Harris Associates and Vin Walden of Thornburg, own this stock for us.
I should note on that point, there are currently six stocks among the top-10 holdings in the fund that have overlap across two managers. I would say this is very little overlap in a portfolio of 60-or-so stocks. It’s in line with what we have observed historically.
We would say when two managers using different investment approaches and style arrive at a similar conclusion on a stock and want to add it in their highest-conviction portfolio of 8 to 15 stocks, it gives a strong indication of its attractiveness, in our mind.
Moving on —
I would just make a point that the fund has exposure to a wide variety of businesses that you could say span across the deep-value and growth spectrum. Overall, the fund is blend, according Morningstar’s category. It doesn’t have a meaningful tail to either growth or value.
On the value side, we have diversified exposure to European financials, and shipping companies. On the growth side, we have e-commerce company JD.com, and gaming company MGM China. Both have a long run-rate for high growth.
Some of these stocks were hit hard in the fourth quarter, due to US-China trade tensions and concerns about slowing global growth. But they have come back very nicely since then, helping the fund’s performance year-to-date. So that’s been a contributor, as well.
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In terms of other allocations, the fund has nearly 7% in emerging markets. If you include China-related Hong Kong listings, this number is in the double-digits. This EM weighting compares to the fund’s primary benchmark — ACWI-x-US index — a weighting of 17% to 18%.
This underweight is in line with the long-term expectations, as our managers are making a very high bar before they favor emerging market companies over developed market ones. They want to make it a relatively-high-quality bias, given they’re running a concentrated portfolio of 8-to-15 stocks.
This is the reason we also compare the fund’s long-term performance versus a developed market index, such as MSCI EAFE.
I’ll stop there in the interest of time.
PS: Perfect. Thank you, Rajat. It looks like we have about five minutes left. We have had a couple of questions come in from the audience. Thank you very much for those.
Jack, we have a question for you and Neil. Could you please provide an overview of the portfolio exposures in the BBH sleeve?
Jack: Yes. Neil, maybe we can go back to Page 12 and talk about how the portfolio’s positioned. The [OIS] and things like that?
NH: Yes, absolutely.
Turning back to Slide 12, basically the average credit-rating in the portfolio is triple-B. Nonetheless, the spread-level — the average option-adjusted spread-level in the BBH sleeve — is 247 bps over treasuries. Just to give you a comparable 4-year triple-B spread-level in the index, it’s about 130 bps.
There’s significant lift there, and I think that is attributable not just to the ABS and CMBS that we talked about, which offer those unfamiliarity concessions if you will; a pick-up in spread due to pretty much the supply/demand technicals. But also, some of the other more off-the-run segments of the corporate market. Some of the attractive compensation we’re seeing in investment-grade and power-project loans.
I think that certainly should stick out. The average credit-quality is quite high. That also helps to limit the return volatility of the strategy.
I think that was evident in the fourth quarter, when as a result of having an anchor to the lower-return volatility of ABS and CMBS in the portfolio. The overall spread-duration of the portfolio being about four years, both of those limited the return volatility during an episode of substantially wider spreads. Even in investment-grade corporates and certainly in high-yield.
The rate-duration is about two years. That is partly as a result of the fact — if you turn to the next slide — of the relatively-large floating-rate component of the loans in the portfolio.
I think the duration of the remainder of the portfolio would be on the order of 4 to 5 years. That rate-duration is driven solely by the duration characteristics of the underlying bonds and loans in the fund.
Should that drift a little bit longer, in the past we have hedged that duration back to around two years. Broadly in the credit-value strategy that we hold, that rate-duration is pretty close to the 1.85 years it currently is at in the sleeve. In other accounts, we might hedge that back half a year or one year to get to that two-year point, using futures.
JC: One other aspect of your portfolio construction —
As we looked around the credit and bond funds out there — strategies — it’s not uncommon to have a couple hundred holdings. But that’s not the case for you. You’re pretty concentrated. Relatively concentrated, compared to most.
Can you address that piece?
NH: Sure.
This is our best-opportunities strategy. We build our portfolios from the bottom-up, bond-by-bond, based on that valuation framework that I mentioned to you earlier.
We do deep credit work. And remember, we’re stressing — prestressing — these bonds to withstand a wide range of economic conditions. For all of those reasons, we do feel comfortable, potentially going up to no more than 2.5% in an obligor in the portfolio.
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That’s certainly not the case for all the positions, but you can think of that as a maximum obligor concentration.
It does result in a portfolio that might have closer to 80 to 120 names, rather than 200 names in another portfolio. We think of this as offering, for very strong credit, the best potential yield and return profile that we can. While still assuring ourselves that we’re not too exposed to anything obligor.
JC: Okay. Thanks, Neil. We appreciate all your time. I think I’ll turn it back over to Pete, for some wrap-up comments.
PS: Yes, absolutely.
We’re bumping up against the end of our time today. I’d like to take a minute and thank everyone for joining the call today. As a reminder, there will be a replay of the webinar posted to the Masters Funds website. If you have any follow-up questions or if you need any additional information on any of the funds that we’ve talked about today, please reach out to the Masters relationship management team and they’ll be happy to assist you.
Thank you for your time. Everyone, have a great day!