Q: Would you give us an overview of the fund and the company?
The BMO Mortgage Income Fund was established in 1992 with a clear intent to create a current income fund that would provide a stable and expectable stream of return to investors.
As is the case with all strategies managed by TCH within BMO Global Asset Management, we always keep in mind the function of that strategy within a diversified client portfolio. The role of this fund is to provide current income and a stable allocation that would serve as a buffer against riskier assets in periods of higher volatility, such as the current one.
The fund is managed by TCH, which is the investment specialist boutique for U.S. fixed income for BMO Global Asset Management. TCH manages about $10.5 billion in institutional and mutual fund assets, while BMO Global Asset Management is one of the top 50 asset managers globally and manages about $221 billion in assets.
Functionally, TCH is an autonomously managed boutique within BMO Global Asset Management. That represents the best of both worlds, as we retain the independence and the nimbleness of an independent firm, while having the resources and sleep-at-night quality of a large global financial institution.
Q: What is your investment philosophy and how is the fund different from its peers?
Our broader investment philosophy is that we owe investors a true-to-style approach. A major differentiator of the BMO Mortgage Income Fund, relative to peers, is that we invest in mortgage securities only.
About 80% of the fund is invested in agency mortgage-backed securities, or MBS, so it is largely a government-focused fund, but the intent is to deliver higher income than a pure government fund invested in Treasuries only, for example.
Our general investment philosophy is that investors need to know what to expect from us. We certainly react to changing market environments and look for opportunities, but only within instruments that are intrinsic to our investment universe. Aside from agency mortgage-backed securities we may consider commercial mortgage-backed securities, CMBS, or make a small allocation to non-agency MBS to increase income, and always remain true to the style of a mortgage fund. In our fund, we do not invest incorporate bonds or equities.
We believe that markets are inefficient but, more importantly, we believe that the most effective way to capture the inefficiencies is by using a balanced, relative value approach to investing. That means adding value over time in equal parts from term structure management, sector allocation and security selection. For the mortgage fund, sector and security selection are the main focus.
Q: How do you translate that philosophy into an investment strategy and process?
Our team-driven approach systematically combines top-down and bottom-up strategies to derive value at the cross section of the two. By design, our process avoids depending on any single factor to drive returns, and thus we avoid creating systematic volatility.
For example, we currently do not believe that there is sufficient compensation for interest rate risk and as such, the duration of the mortgage income fund is managed within 20% of the benchmark duration. Instead, we are looking to deliver value from term structure, considering all the macroeconomic and technical factors and the unique characteristics of any given market environment and anticipating non-parallel shifts in interest rates.
In today’s market, the low interest rate environment is a key focus. If we believe that interest rates will remain fairly stable and the yield curve may flatten, we would prefer conventional 30-year mortgages, for example. If we think that the housing market has recovered sufficiently to represent a stable environment, we may allocate to some non-agency residential mortgage-backed securities to deliver additional stable income.
But that’s not enough—at least not to us as we manage the BMO Mortgage Income Fund. As a more nimble manager, we are uniquely positioned to pick the specific securities that are most attractively valued to execute the top-down strategy. The process is about identifying a pool of securities with specific characteristics that would be particularly attractive in realized returns going forward. It’s not just about a preference for 30-year conventional mortgages in a particular environment.
The agency MBS market can be divided by vintage, maturity, and agency. Within each of these general cohorts, there are specific pools of loans under the umbrella of one security. We believe there are opportunities to add more value from the bottom up by selecting individual specified pools. We don’t buy just a cohort, but instead select securities backed by specific loans with specific characteristics, such as lower loan balance, for example.
Risk management is a key aspect of our investment management process. For the BMO Mortgage Income Fund, we apply risk management from two different perspectives. The first one is being true to style and the second perspective is total return, because investors’ bottom line is ultimately affected by absolute rather than relative returns.
Q: What is your research organization? How do you look for opportunities?
An important differentiation from our peers is the team-based approach to management. We don’t believe in the “star manager” system. The three functions within investment management - portfolio management, research, and trading - work very closely together and have equal ownership of the process and the results.
We have a team of six portfolio managers, six research analysts, and two traders that support the management of all our investment strategies, including the BMO Mortgage Income Fund.
Another point of differentiation is that we rely on independent in-house research. Our research process is fundamentally driven, but quantitatively anchored. The market is not homogenous, so it is important to have appropriate quantitative tools and systems at hand. Every individual security has precise and different characteristics that must be measured appropriately and compared to the entire universe to make relative value judgments.
Q: Could you explain through an example how an idea becomes a holding?
We start with our global investment framework that is well defined as the anchor. The top-down process establishes the broad themes for term structure positioning and sector allocation in terms of interest-rate positioning and sector allocation among commercial MBS, non-agency securities, and agency MBS. The top-down process helps us define which segments of the universe are more compelling in the current environment.
Once this framework is determined, we populate the strategy with individual securities. If we decide to increase our allocation to conventional 30-year agency MBS, for example, we look specifically for the securities that fit our themes and have compelling underlying characteristics.
Depending on the theme, we can drill down within the entire cohort and determine the appealing characteristics depending on our current investment strategy. Then we work with our traders, utilizing their expertise to identify the most attractively priced specified pools with those characteristics.
For example, in the current environment, agency MBS tend to trade at a premium, above 100 cents on the dollar. In general, agency MBS do not carry embedded credit risk. Fannie Mae and Freddie Mac are believed to have an implicit guarantee of the U.S. government, while Ginnie Mae has the explicit guarantee. Thus the principal risk to consider is prepayment risk.
Prepayment risk is the result of an investor refinancing or repaying a loan faster than anticipated. Low loan balances have less prepayment risk because the incentive to refinance a loan of $100,000, for example, is much lower than the incentive to refinance a mortgage for a $500,000 home. In turn, a low loan balance agency MBS is more attractive.
We may also look for pools with lower FICO, as people with worse credit score may find it more difficult to refinance. Certain states tend to have lower turnover, such as New York. Investor properties also tend to have lower turnover, so the incentive to refinance is lower.
Overall, we aim to purchase a pool of loans that over time would prepay more slowly than a typical agency MBS. That characteristic would result in excess return for the portfolio over time.
Q: What has been the prepayment rate on a 30-year conventional mortgage?
The standard prepayment rate often applied to mortgages was about 8% in the past. However, we have been living in an unusual environment for a long time. Because we have had many refinancing waves in a low-interest rate environment, prepayments escalated to 30% or 40%, and even higher, depending on the coupon.
As I mentioned, the agency MBS market is divided in different cohorts and the coupon rate is one of the characteristics of these cohorts. The coupon is reflective of the interest rate that the underlying loans carry. The higher the interest rate on the loan, the greater the likelihood for prepayment. A higher coupon mortgage would carry high prepayment risk. With interest on the underlying loans of 5.5%, for example, the risk would be quite high as the primary mortgage rate is currently around 3.7%. Borrowers have extremely high incentive to refinance, and they would likely do so quickly.
Conversely, the 3% cohort would be prepaid much more slowly because the financing incentive is lower for the underlying mortgages. So, depending on the coupon cohort, the prepayment rate can be as high as 50% or as low as 0%. It varies considerably across the spectrum.
Q: What is your portfolio construction process?
The focus of this fund is agency MBS, so our benchmark is the Barclays U.S. Mortgage-Backed Securities Index. However, we don’t intend to mimic the index; we use it broadly to benchmark the overall characteristics of the fund.
At least 80% of the fund has to be invested in agency MBS. Within agency MBS, we can invest in traditional securities, but also in agency collateralized mortgage obligations, or CMOs. For example, when we anticipate a very volatile environment, agency CMOs give us the opportunity to capture more stable cash flows.
Within the remaining 20% allocation, we invest only in securitized assets. We don’t invest in corporate securities or equities, like some of our peers. That allocation is invested in either agency CMBS or in non-agency residential and commercial mortgaged-backed securities (CMBS).
We avoid owning more than about 5% in any given individual agency MBS. The typical allocation is about 2%. For non-agency MBS or securities that are exposed to more risk, our allocations of about 1% to 2% each.
Q: What is the purpose of the allocation outside the agency mortgage-backed securities?
There is a dual strategic purpose of that allocation. First, in the current volatile environment, the agency MBS class is exposed to volatility because of the prepayment risk, while CMBS mitigate some of that risk and provide more stable cash flow.
The second purpose is to respond to the very low interest rate environment, where the 10-year Treasuries have been as low as 1.5% this year. In such an environment, we would look for higher income opportunities away from agency MBS, but without taking significant incremental risks.
Q: How do you define and manage risk?
We look at risk from two different perspectives. First, it is the deviation relative to benchmark because it is important for investors that we remain true to style. One important way we control that risk by defining target allocations. There is the minimum 80% allocation to agency MBS, as well as the commitment to securities that exhibit substantially similar characteristics as the benchmark.
The second aspect is absolute risk, which is integral to our process because we focus on total, not just relative return. I already mentioned the prepayment risk. When interest rates decline, as they have done recently, borrowers can refinance their homes at much lower interest rates. In turn, the prepayment risk of MBS increases. If we anticipate a further and substantial decline in interest rates, we would look for securities with lower prepayment characteristics to mitigate risk.
The flip side of the same coin is the extension risk. If interest rates increase quickly, prepayments of MBS slow down, the maturity extends considerably, and the yield earned would be different. So, the extension risk is similarly mitigated by loan characteristics. CMOs, for example, deliver more stable cash flows regardless of the prepayment environment.
The other aspect of absolute risk is related to non-agency securities, which do not have the backing of the agencies. Here, the focus is the management of the embedded credit risk. We compare the credit enhancement of each individual security with the underlying collateral characteristics of the loans backing the security. Based on that analysis and using our internal proprietary tools and also third-party systems, we asses absolute credit risk.
