Q: What is the history of the fund?
Braddock Financial, LLC was founded by Harvey Allon in 1994. Mr. Allon, who had managed the Residential Mortgage Backed Securities (RMBS) trading desk at Nomura Securities, is considered one of the pioneers in the mortgage and structured finance space. In the late 1990s, he started investing in mezzanine and subordinated debt, primarily RMBS securities.
The Braddock Multi-Strategy Income Fund (the “Fund”) started on July 31, 2009 and was our first foray into the mutual fund industry. Initially, the fund was private, but at the end of 2015, we opened it to the public. Braddock Financial, LLC is the fund’s sub-advisor.
Q: What is your definition of multi-strategy?
Our objective is to make money from both income and capital appreciation. Basically, we are a fixed-income fund with the flexibility to invest across the structured finance markets. While we are primarily focused on RMBS, we also invest in the Asset Backed Securities (ABS), Collateralized Loan Obligations (CLOs), and Commercial Mortgage-Backed securities (CMBS).
Our definition of multi-strategy is a fund that has ability to alter its allocations to various segments of the structured finance market depending on market conditions. This is expanded by our ability to invest up and down the capital stack (Investment and Non-investment grade bonds). The Fund also has the ability to hedge its long positions in periods of high market volatility. It should be noted, we do not invest in dividend-paying or preferred stocks, so the fund has no equity exposure.
Q: What core beliefs guide your investment philosophy?
Our approach to investing can be described as opportunistic in that we seek investments offering the best risk-reward profile. We analyze the current state of the market cycle and the behavior of other buyers and sellers. Then we position ourselves to capitalize on gains from sectors that are trading out of line with our view of their market value.
Keeping abreast of the macro environment is also an important part of our investment strategy. Estimates of economic growth and the expected shape of the yield curve are always factored into our investment decisions.
For example, if we were to believe that interest rates will increase at a slow pace in the near term, we will increase our exposure to floating-rate securities. Then, if we were correct and short term interest rates increased 100 basis points, the coupons of the floating rate bonds indexed to short-term indices in our portfolio would correspondingly increase.
At this moment, we are keeping our effective duration, or interest rate exposure, very short due to the high floating-rate nature of the bonds in the fund.
In the three-to-five-year period, if we believed that interest rates were going to flatten out, or perhaps even fall, we would invest in a more balanced spread between fixed and floating-rate securities.
Q: What is your investment process?
We are a fundamentally based investing shop. Our bottom-up approach is aimed at identifying securities that offer the best risk-reward profile considering both the underlying collateral and the structure of a fixed income investment.
Early on, Braddock realized the importance of having access to good fundamental data. So, we built a mortgage, loan-level database, which contained millions of mortgages with detailed information on how the loans have performed month-by-month since their initial origination. We use that tool to better assess the underlying value of the mortgages based on location, socioeconomic status, and type of loan.
The overall process includes numerous scenario and sensitivity tests of each potential investment and its effect on the overall portfolio.
Given our yield curve expectations and top-down evaluation of the U.S. housing and consumer sectors, we undertake a risk management process that analyzes the relationships between our markets and corporate credit spreads across the investment grade and high-yield market. Using a weighted average procedure, we evaluated credit spread risk to form a risk perspective for which we are comfortable.
Q: Who issues the floating-rate bonds?
In the structured finance space, you are dealing with pools of loans that have been sold into a bankruptcy remote trust. The bonds issued by the trust can either be fixed or floating-rate. As floating rate bonds, the coupons paid are usually indexed to the one or three-month LIBOR rates plus a spread. Alternatively, they may be a pass through of the average mortgage rate paid on the underlying loans which is called the weighted average coupon.
Q: How do you assess credit quality?
We buy roughly an equal split between seasoned bonds in the secondary market and newly issued bonds. The analysis we use in evaluating the bonds varies between the two types.
For the seasoned securities, we use our loan-level database to determine the actual performance to date of every loan backing the security. We can see how many mortgages are current, delinquent, or have been modified due to a borrower’s financial hardship. If a loan is in foreclosure, we can evaluate whether it is likely to lead to a loss and what impact that loss will have on the bond’s risk, volatility, and underlying cash flow.
On the new issue side, which we consider as a security issued after the financial crisis, we evaluate both the loan originator and the associated underwriting guidelines to see if we believe their guidelines are appropriate.
In particular, we check that the originators are doing full documentation on the underlying borrowers: verifying income; making sure the appraisal is correct; and checking if the product fits the borrower. In the wake of the financial crisis, there is a whole set of new rules to ensure that the borrower has the ability to repay the loan.
Finally, we forecast prepayment and default rates of the loans over the life of the trust. That helps us decide which bond provides the best risk-reward profile.
Another area we carefully evaluate for both seasoned and new issue securities is the servicing agent. There are a number of loan services that we monitor.
It is also important to know the securitization trustee to ensure that they will provide timely information back to bondholder. We receive monthly reports which tell us how much principal and interest was collected from the underlying loans and how that money was distributed to the various bonds associated with that trust. We have to track that information to make sure that it’s done correctly each and every month.
Q: Do you rely on rating agencies or on an internal rating system for researching bonds?
There is no doubt that the rating agencies had a tough time during the financial crisis and lost credibility as did most loan originators. But bond agency ratings are still very important because they help determine the market demand for the securities. Before we invest, we need to determine the potential depth and liquidity of the buyer base for a bond. The closer it is to an AAA rating and the more liquidity it has and the larger will be the potential buyer base.
As ratings can improve as the bond ages, ratings help us understand not only who is interested today, but will be interested in owning the bond in two or three years. For the securities for which we have a potential interest, we monitor the seasoning and how that may affect the future price.
Q: Is the anticipation of a rating revision a good investment opportunity?
Yes, ratings migration is part of our strategy. For instance, suppose we buy a bond that we believe is underrated at BB when our credit estimate is BBB. If that bond is upgraded in 18 to 30 months to a BBB or even an A as we anticipate, we will profit from the capital appreciation.
Q: How do you utilize macroeconomic indicators in your investment strategy?
Although we carefully monitor a variety of economic indicators, our primary focus is the U.S. housing market and the consumer side of the economy. On an ongoing basis, we track indicators like U.S. household formation rates and changes in mortgage applications.
One of the most important indicators we follow is the Mortgage Bankers' Association’s Mortgage Credit Availability Index. It provides an indication of how strict current guidelines are for getting a mortgage.
For the U.S. homebuilding industry, we maintain a general supply and demand profile. At the current time, with household formation exceeding new construction, we expect housing and mortgage finance to demonstrate strength over the next five to 10 years.
On the consumer side, we follow statistics like consumer default rates, debt-to-disposable income, personal savings-to-disposable income, and consumer confidence. The numbers suggest that the U.S. consumer is currently well positioned to service their credit card and mortgage loan payments.
Q: Can you describe a couple of security sectors that highlight your research process?
One area of interest is the Credit Risk Transfer deals (CRT) undertaken by the government-sponsored entities like Fannie Mae and Freddie Mac. The bonds are issued to help the government unload some of its direct debt obligations. Roughly 80% of new home loans today are held by Fannie Mae and Freddie Mac, which puts a taxpayer on the hook for most of the countries potential mortgage defaults.
So, the government initiated a credit risk transfer program to transfer some of that mortgage risk back to investors. We started participating in these deals when they started in 2013, with investments across the mezzanine and subordinated debt stack. And the deals have worked out well.
The mortgage pools underlying these bonds are experiencing exceptional performance with delinquency rates from 15 to 35 basis points—well under 1%. In addition, the number of institutional and money managers investing in this space has grown over time which has led to excellent liquidity. It has not only been a profitable investment, but it has had the added benefit of being all floating-rate paper.
Another area of interest, although much smaller, has been debt backed by home rentals. Following the financial crisis, mortgage loans became difficult to obtain. As a result, many households turned to renting single family homes. Several publicly-traded REITs were formed that purchased large numbers of homes and offered them as rental properties. They financed their purchases by issuing bonds that were backed by the monthly rental revenue. If the REITs were unable to service the debt, the bondholders could foreclose on the underlying houses to pay back the debt.
In the last few years, vacancy rates have fallen, rental rates have increased, and the debt has performed extremely well. When we bought those bonds, they were rated BB and now many of those bonds are investment grade.
Q: What is your outlook for existing home sales and new home construction?
I believe that existing home sales are back to the overall level that we saw before the crisis, but new home sales are still lagging slightly. It has taken the homebuilders a long time to get comfortable building homes as the profit margins remain thin. Also, when we look at entry level homes, it has been harder for first-time home buyers to find homes that are affordable and then to secure financing.
Moreover, the amount of inventory on the market is very low compared to historical norms. The home ownership rate has fallen from over 69% to 63%. So, we really do need to see a boost in home construction to satisfy the rate of household formation.
