Subprime is still a dirty word for many investors, so it’s perhaps unsurprising that many fund managers who operate at this end of the market prefer to speak of ‘non-agency’ bonds instead.
This fund has provided outstanding risk-adjusted returns over the past three years, with the managers’ personal information ratio standing at 2.15 for the period. Their total returns are more than double those of their next closest peers too.
Miner, Smith and Loo have primarily achieved this by investing in non-agency residential mortgage-backed securities, particularly on the subprime side. For Miner and his colleagues, subprime has plenty of attractions: a dwindling supply of housing-backed floating-rate securities, less reinvestment risk in such assets because the securities are longer, lower-priced homes tending to outperform higher-priced homes, the boost from the recent tax reforms, and the fact that many deals could be called given the decreasing delinquency rates in the market.
Garrison Point Capital is not alone in identifying these opportunities. AA-rated Scott Minerd and the AAA-rated trio of Adam Bloch, Anne Walsh and Steven Brown run a broader fixed income mandate in the Guggenheim Total Return Bond fund, but non-agency residential mortgage-backed securities are still their second-largest allocation, despite being off-benchmark.
‘We maintain our long-running constructive view on non-agency residential mortgage-backed securities, as healthy housing fundamentals and improving borrower performance support the sector,’ they explained. ‘Strong demand and muted new home construction have pushed inventories to historically low levels, in turn boosting home values. Against this backdrop, ongoing credit curing of legacy mortgage-backed securities borrowers should result in improved prepayments and loss rates on bonds, and it has already emboldened greater risk taking by lenders and investors.’
‘We continue to find non-agency mortgages very attractive for the higher-yielding portion of the Income strategy,’ Murata said. ‘We think of the sector as a “bend but not break” asset class. Prices could be volatile in the near term, but we believe loss of capital is unlikely. Even if house prices were to decline, we think yields on non-agency mortgages will still be higher – after taking defaults into account – than Treasury yields.’
Murata added that the non-agency sector was continuing to shrink too, winding down from roughly $2 trillion in 2007 to around $500 billion now. This was a theme also highlighted by AAA-rated Thomas Mandel of the Semper MBS Total Return fund. ‘The legacy non-agency residential mortgage-backed securities market continues to contract slowly, with current estimates now at a little under $500 billion,’ he said.
‘But, very importantly, the new issue sectors continue to expand. Issuance may hit as much as $100 billion this year, and our view continues to be that Semper Capital is the right size to take maximum advantage of the opportunities in this market.’