Q: What is the history of the fund?
Semper Capital Management, L.P. is a multi-billion dollar registered investment advisor. We have been deploying our expertise in residential mortgage-backed securities, commercial mortgage-backed securities and asset-backed securities, which comprise about $7 trillion of the U.S. fixed income landscape. After 2008, we saw an opportunity and developed a mutual fund, which is a dedicated mortgage-backed securities product with a distinct and differentiated offering.
Q: What is the main differentiator of the fund?
By mandate and thesis, this fund has a dedicated focus on mortgage-backed securities and Semper has an investment team, which has been managing the asset class for decades. Its platform is a combination of human capital experience and math in a market that remains structurally fragmented, opaque and with significant complexity premium built into the space. We’ve made the business decision to be deep in a skill set as opposed to having a broad product offering. That also differentiates us.
Q: Would you highlight the advantages of investing in mortgage-backed securities?
The value proposition of the fund breaks across three dimensions. First, mortgage-backed securities offer an advantage yield profile in a challenging low-rate environment. It’s a great solution set for investors who want yield enhancement within their fixed income books. Second, we are able to construct the portfolio with limited duration and sensitivity to interest rates as this is an asset class with limited exposure to rates. Third, for structural reasons the asset class has little volatility and correlation to traditional risk assets.
The mortgage market has two binary parts. There are agency mortgage-backed securities like U.S. home loans, which have been issued, securitized and sold through one of the government agencies. The investor in that pool of securities is not taking on credit risk, but is making a bet on interest rates and pre-payment speeds. The second part is the non-agency mortgage portion of the market, or the U.S. home loans, which have been issued by banks across the country. The investor in that pool is taking on straightforward credit risk and is being compensated for that.
There are dozens of inputs, assumptions, and variables that go into the fundamental analysis. For thousands of loans, we analyze to determine if they are going to be paid off at their normal rate or if they will default. If they default, what would be the process and timing for turning them partially into cash? Non-agency mortgage-backed securities allow investors to indirectly access the U.S. homeowner from a credit perspective and to make a credit bet on that part of the economy.
From an economic and credit perspective, we believe that the non-agency mortgage space is one of the strongest credit bets available. These are pools of thousands of individual U.S. residential home loans. The factors that effectively drive the credit quality of that collateral are home prices, GDP, wage growth and rates.
The structure of the non-agency space is another source of value. This market is traded over the counter. There is no index or exchange marketplace for price; the market is massively fragmented and fairly opaque. So, the ability of a specialist, with an active management bent to find value in this market and to exploit the complexity premium, is embedded from a structural perspective.
Another factor is that, technically, these securities originated and were issued before the crisis, or between 2002 and 2008. Today, about $500 billion of the existing inventory is still on the market. In the natural course of business, as people pay their mortgages, that market shrinks at a rate of about 10% per year. This technical dynamic adds to the attractiveness of the asset class.
So, there is a multi-pronged backdrop, which we believe makes the space one of the best sources of risk-adjusted returns in the market today. Our fund is currently about $1.4 billion in size. The mortgage credit market of about $500 billion is traditionally invested by large institutions, and it is our view that we can make a difference with our nimble and opportunistic style of portfolio management.
Q: What core beliefs drive your investment philosophy?
The mandate of the fund is to drive an opportunistic return, but with a heavy focus on capital preservation and risk mitigation. Our governing principle is to not lose money. Within the fixed income universe, we are a quantitative value shop.
We have a bottom-up approach to understanding each asset and its cash flow generation potential. We analyze and in essence re-underwrite the credit of each and every loan. We constantly and actively manage the portfolio on a relative basis, trying to optimize around the strongest risk-adjusted return profile that we can build. But from a fundamental standpoint, we are a bottom-up quantitative shop and we take comfort in deploying our skill set and understanding of the actual cash flow potential of each and every asset.
We have a total return mandate within the market opportunities and a focus on risk mitigation. We believe that we can deploy our expertise to evaluate what the market is offering from a value and yield perspective and we’ve been successful in articulating to investors what they should expect from a return perspective.
Q: Would you describe the steps in your investment process?
The foundational approach to our portfolio construction is proprietary loan level credit model. We have built, in-house, the ability to take any particular bond, deconstruct it into its underlying loans, make very detailed cash flows for each and every loan, roll those cash flows back together, and understand how that aggregate cash flow works in a particular bond structure.
Then we come up with a bottom-up perspective on the mathematical potential of that particular security. The credit model allows us to have a granular understanding of value, of the potential yield at various prices, and the worth of the bond under different scenarios.
The second stage of the process is related to the human capital element. We have a dedicated investment team of 10 professionals, who interact with Wall Street on a continuous basis. They take the perspective the model has given them on the value of any particular bond. The model screens hundreds of bonds daily. The structural characteristics of this market allow a nimble, active manager to drive value first from quantitative-based analytics on how bond or collateral will behave. Then we add value through our team, which utilizes that knowledge to trade positions.
We also have a top-down perspective and macro inputs, such as housing rates and an economic forecast, which filter into the model. However, our screening tool is mostly a bottom-up asset-based credit model, which gives us the confidence and the intellectual grounding of what we believe a bond should be worth in different scenarios.
Q: What variables do you look at?
We analyze every loan across dozens of metrics and inputs. They include purpose of the loan, servicer, bank, sub-servicer, legal ramifications, geography, etc. There is differentiation of how we view and price various loans and securities. That is combined with the general perspective that there is no such thing as a bad bond, only a bad price.
If after applying the independent assumptions to a loan or a package of loans, a bond still shows greater relative value, we will potentially buy it. Again, it is not the top-down perspective that drives the construction of the portfolio, but the bottom-up analysis, nuanced by dozens of top-down inputs that influence how we think about loan A versus loan B versus loan C.
In the portfolio construction process, we are focused on liquidity and diversification. We ensure that even with a bottom-up granular identification of value, the portfolio is always diversified across all the traditional metrics like position size, loan type, security type, sector allocation, etc.
Q: What factors guide the asset allocation decisions?
By design, we have to be 80% in mortgages, but we can go anywhere within the mortgage universe. So, we would analyze every sector of the market. Due to our internal diversification guidelines, we would never dramatically expose the fund to any particular sector. But one of the advantages of the space is that it is so fragmented and nuanced, that there is a lot of value to extract.
We have the tools to compare subsectors with different dynamics, characteristics, and structures, to deconstruct them to their baseline asset level and to understand and compare them. After two different subsectors run through our model, we turn them into similar sets of cash flows that can be analyzed, discussed, and evaluated on a relative basis. That’s active portfolio management.
Our top-down macro thesis is that mortgage credit, as an asset class, is one of the best sources of risk-adjusted returns. But we actively manage the portfolio as evidenced by our sector or subsector allocation and our turnover statistics. If we have the chance to hold yield constant and decrease risk, or hold risk constant and increase yield, we will make that trade. Turnover at the portfolio level is two to three times on an annual basis as we actively manage to drive value.
Q: Who makes the final decision to include an asset in the portfolio?
As a platform, we manage multiple products, including this strategy. As Chief Executive Officer and Chairman of the Investment Committee, I evaluate the portfolio manager on hitting his or her objectives. At the highest level, decisions fall on the portfolio manager, who is supported by sector specialists with significant autonomy within their sectors. So, the portfolio manager makes buy and sell decisions at the sector/subsector level, but the sector specialist is the one analyzing specific bonds.
That’s a transparent, accountable process. The sector specialists own the positions and are held accountable by the portfolio manager to deliver on the instructions they were given. Once purchased, the bond position is monitored for price and performance and is constantly re-evaluated.
Ultimately, from a business and investor perspective, the portfolio manager is responsible for everything that is or is not in the fund. At the position level, the sector specialist is responsible for the evaluation, maintenance, and monitoring of any given position and/or idea.
Q: What is your buy and sell discipline?
On the buy side, there is constant evaluation of relative value. On the sell side, if a bond is performing weak from a relative value perspective, we can be opportunistic and sell it. And from risk mitigation standpoint, if a bond is not performing due to price or collateral behavior, the risk committee can force the sale.
At the time of evaluation and purchase, we analyze every loan that can price a bond. We document dozens of assumptions around how each loan is going to perform. The monthly remittance reports in the market validate or invalidate our initial assumptions, such as did home prices go up in that region or not, did defaults come down or not, did pre-payments stay stable or not, did more people fall from 30-day delinquent to 60-day delinquent or not.
There are dozens of real-time metrics that are reported monthly and allow us to constantly compare how we believe the cash flows would act and how they are actually acting. In conjunction with price movement, that allows us to be vigilant. If the price of a bond falls, there is a forced review of the collateral and re-underwriting of the opportunity set. If the loans in a bond underperform from a credit perspective or assumption set, there is a forced review and re-underwriting of that particular asset.
Our risk committee meets on a weekly basis and there is a constant formal review of the performance of the assets both from price and from collateral perspective.
Q: What is your portfolio construction process?
This is a total return fund with no mandated allocations or limits on allocation to various sectors and subsectors. The only mandated guideline is that the fund needs to be at least 80% in mortgage-backed securities. We have internally driven guidelines that limit the position size to 5% of the fund and the sector allocation to 25% of the fund.
In the construct of searching for relative value, the largest portfolio construction driver is ensuring that we build a portfolio that is appropriate from credit and liquidity perspective.
We think about liquidity across three dimensions. First, we consider liquidity at the bond level. The sector specialists evaluate how long it takes to sell the bond at the mark or right away. That information is filtering up to the portfolio manager. Then, the manager considers laddering the liquidity of the portfolio. For instance, what percentage of the fund should be immediately liquid? And finally, from an operational perspective, we can redeem up to 20% of the fund utilizing a credit line from our custodian bank.
So, the combination of the granular perspective at the bond level, the portfolio manager laddering the liquidity of the portfolio, and the operational credit line allow us to manage liquidity effectively.
The benchmark of the fund is the Barclays Capital U.S. Mortgage Backed Securities Index.
Q: How do you define and manage risk?
At the highest level, avoiding risk is avoiding drawdown or losing capital. For us, there are three levels of risk. The first one is the credit component. Since we make mortgage credit bets, we need to ensure that from a credit perspective the intrinsic value of the cash flows we are buying is not impaired and can perform in various forward looking scenarios. So, we have a heavy focus and a bottom-up perspective on the credit component of what we buy, centered on our loan level credit model.
The second component is technical risk, which can drive pressure on various asset classes. The factors that go in this analysis are performance of mortgages, falling stock market, geopolitical risk, rising interest rates, bond market sell off, etc.
The third component is liquidity risk. Because this is an over-the-counter sector, we never want to be forced to sell a bond at the wrong time. So, we manage risk across three dimensions - credit, technical and liquidity. The portfolio managers construct the portfolio and select bond based on the three type risks that they manage around.
