Deep in the MBS Skill Set
Semper MBS Total Return Fund
Author: Ticker Magazine
Last Update: May 29, 9:01 AM EDT
|Unlike other funds offering broad coverage, the Semper MBS Total Return Fund leverages its expertise in mortgage-backed securities. Greg Parsons, CEO and Chairman of the Investment Committee, believes that the MBS space is one of the best sources of risk-adjusted returns today when actively managed by a specialist. With a focus on capital preservation, the fund relies on a complex quant model and a set of principles refined over time.
“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 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.