Education of a Bond Manager, Part II

Education of a Bond Manager, Part II

In much of my life, I have been thrust into situations for which I was not ready, and ended up rebuilding the wheel, or came up with an unorthodox approach that worked. But a lot of the problem came down to the question of time horizon. How long can you buy and hold, even if temporary market conditions make you squeamish?

I remember the first CMBS bond that I bought in 1998: it was the longest AAA tranche of a Nomura Holdings, Inc. (TYO:8604) (NYSE:NMR)  deal, which was out of favor at the time. I did a lot of work analyzing the deal, and concluded that the bond was a lot safer than many competing bonds and offered more yield. In early 1999, when I described this purchase to the investment committee of a charitable board the I was on, one said, “Only 7%, and you are locked in for 14 years?” I said that stock valuations were high, and that 7% was a great return. It was a great return, and far better than the stock market over the same time period, though I could not have known that at the time.

I became an advocate for CMBS in my firm as I realized that the hot product being offered would have the majority of its cash flows come at the 10-year maturity, but there would still be some level of withdrawals. After some modeling, I realized that the best strategy was investing 80-85% of the money 10 years out, while leaving 15-20% of the money as pseudo-cash: 2 years out or shorter. Of all of the mortgage bond categories, only CMBS offered assets with a ten-years or more duration, with minimal credit risk.

I used Charter/Conquest as my software. It enabled me to set a consistent set of macroeconomic principles to evaluate a large number of properties in different economic areas. The software would project the cash flows of each property, given the assumptions that you fed it.

I spent time analyzing geography and property types. I had a decent idea as to what areas of the country were doing badly, and with what property types.

I created what I called the black bucket. Property types and geographic areas that I did not like were assigned to the black bucket, and if the black bucket got big enough, we did not play in the deal. It was a good method, and one CMBS expert at a bulge-bracket bank said to me that it was the most rigorous means of testing CMBS that he had run into. Most buyers were far more trusting, and tended to buy quality issuers that were taking advantage of their reputation.

By having an independent standard of value where I worked, I did better than competitors. I did not follow fads; I followed value to the greatest extent that I knew.

Brokers would be puzzled on why I turned down deals from good dealers, or why I bought deals from originators that were subpar. My lesson was dig into the details, and ignore names. Analyze the data, avoid the marketing.

Doing your own analysis is a lot of investing. Ignore the puzzled expressions of your brokers, and buy what you have determined is valuable. More in part 3.

 By David Merkel, CFA of  alephblog