Chilmark Air 2017 LLC letter for the fourth quarter ended December 31, 2015.
The fourth quarter of 2015 was an opportune time to launch Chilmark Air 2017 LLC (the “Fund”). Credit markets declined during the quarter as investors large and small withdrew capital from hedge funds and mutual funds. It is easier to build a portfolio for a fund such as Chilmark Air in a declining market than during the stimulus-fueled rallies of recent years.
The Fund showed a 1.09% decline in the fourth quarter. However, our performance compares fairly well with benchmark indices, as illustrated in the table below.
This first investor letter for Chilmark Air 2017 LLC will include a discussion of my investment approach and philosophy. Future letters may discuss market developments and portfolio holdings in depth, but will likely be shorter.
Chilmark Air 2017 LLC - Investment Approach & Philosophy
“Markets look a lot more efficient from the banks of the Charles than from the banks of the Hudson.” --Fischer Black (after leaving MIT for Goldman Sachs)
My investment approach is the product of three perspectives: my experience as a bond dealer at Lehman Brothers, my time as head trader at Cerebellum Capital (a quant fund), and my study of the distressed debt strategy used at Oaktree Capital, the $90 billion fund run by Howard Marks.
Lehman Brothers: Trading bonds at Lehman Brothers taught me that not all decisions on the sell side are made with profit in mind. Investment banks have many incentives and they often conflict. Fees charged for stock offerings and new debt issues make up a large part of a bank’s profits; the bank’s traders are therefore willing on occasion to lose money to support the longterm profitability of those business lines. In addition to intentional losses (which are typically small) there are also unintentional losses. In my time as a market maker I certainly made mistakes, all traders do. It’s easy to get caught short a security in a fast moving market, or to accidentally take on too much inventory when the market looks strong. Knowing that these mistakes are an inherent part of the business, I look for opportunities to be there to buy securities that a dealer needs to unwind following a mistake or to sell when regulatory pressure forces them to liquidate.
Mistakes from other investors come to my attention as well, sometimes with details that are both funny and sad. I was contacted by a salesperson who said his client needed to sell all of their bonds “as part of a bankruptcy liquidation. All bids must be submitted to [his] lawyer for approval, which might add several days to the process.” When a lawyer is managing the liquidation process we’re well beyond the realm of efficient pricing. To put it another way, when your back is against the wall, you might sell cheap, but if you go bankrupt your lawyer sells cheaper!
Cerebellum Capital: Running the trading desk at Cerebellum Capital for three years was a great way to get current with quantitative trading (an approach I have used in the past, not to mention that my father has been a quantitative investment manager since the 1980s) and it provided a “view from the trenches” of the battle between quant investors and their more “fundamentally-driven” competitors. From that vantage point, it is clear that quant investing works, but not necessarily at all sizes and scales and sometimes it works too well and things get crowded and annual returns drop to low single digits.
Post-Cerebellum my conclusion is that one needs to be selective when considering quant strategies. Successful players in the industry have at least a billion in capital as well as a team of 30 or more researchers able to explore many strategies at once. But what about the set of securities which don’t work for such funds? In the age of automated and high frequency trading, what part of the market is safely out of reach of quants? Their domination of markets may or may not be inevitable, but what is certain is that they are making more progress in some markets than in others. Anything that requires lots of reading, or is made up of heterogeneous parts, or can only be traded via telephone is relatively safe from the competition that these traders bring. On one end of the spectrum are stocks which are liquid and viable for trading using automated methods, and on the other end of the spectrum are real estate and leases/loans, which are truly difficult to trade electronically -- there are too many nuances and legal matters which must be considered. A good example from our portfolio would be a late-90s aircraft leasing securitization, collateralized by a mix of Boeing and Airbus jets of varying ages and engine configurations. Not the ideal thing to try to model with math and software!
Oaktree Capital: The saying that “all good investments begin in discomfort” is true, especially for distressed debt investing. While the advice of an industry legend can never help one decide whether to pull the trigger on a given opportunity, the philosophy used by Oaktree Capital (credited to Howard Marks and Bruce Karsh) combined with my own experience is useful in narrowing the universe of bonds to the few that are the best combination of risk and reward. Much of what Oaktree has published is vague or non-specific. For example, Marks’ quote that “the only way to make money is to buy something for less than it’s worth” sounds either simplistic and obvious, or near impossible, depending on what you believe about the efficiency of the markets. This advice is not, in fact, helpful to the equity investor but for me as a bond investor its meaning is much clearer. If we consider a bond backed by loans or leasing assets which are in a state of serious distress, combined with a bond structure which is failing or broken (in other words multiple classes of the bond structure are no longer paying and will never receive cash flow again), and further combined with a seller who is liquidating their fund one can see how it is possible to buy something for less than the sum of its future cash flows. No catalyst is required to unlock this value; over time the cash flows will be paid to the investor.
In summary, my approach combines the following:
- Stay in close contact with bond dealers and be alert for mistake-driven selling by traders or investors.
- Limit the universe of investments to those which do not fit quantitative investors.
- Purchase bonds with distressed loans/leases, broken structures, and sellers in their own state of distress.
In applying the approach, I try to view it as a constant “advantage” or “profit margin,” which reduces the need for forecasts and predictions. To make an analogy to real estate investing, I act more like a "real estate developer/landlord" than a "real estate speculator." In a downturn, the latter would be at the mercy of mark to market declines in real estate because his or her strategy profits by buying properties and later selling them at higher prices. The former is of course also exposed to real estate mark to market, but he or she also tries to earn profits from renting and leasing real estate and then to use that cash flow to purchase more real estate as opportunities arise. Cash flow from a real estate portfolio does not decline immediately when prices decline -- it takes time for rentals and leases to expire and reset. In a similar way, a downturn would trim our aircraft lease revenue, but in some cases not for an extended period because of the length of our leases. Cash flow coming in would be used to purchase more Aircraft ABS at the new, higher yield levels associated with the downturn. Hopefully that helps you think about how I would respond to changes in market conditions: "like a business would" as opposed to “like a trader would.” Not that one way is right or wrong, that's just the style of this strategy and in my judgment it fits these assets better than a trading strategy.
Chilmark Air 2017 LLC - Portfolio Composition
The Fund’s holdings can be broken down by asset type: Aircraft ABS and Enhanced Equipment Trust Certificates (EETC), Mortgage-Backed Securities (MBS), Collateralized Loan Obligations (CLO) and exchange-traded products.
Chilmark Air 2017 LLC - Aircraft ABS & EETC
The core of the Fund consists of securities that receive cash flows from aircraft that are leased to airlines and air cargo carriers. These bonds offer several advantages:
- There is no direct exposure to airline bankruptcy. Instead, our primary exposure is the demand for business and leisure travel.
- The aircraft we own are purchased at a steep enough discount to compensate for their depreciation rate.
- The aircraft market, while large enough to suit the needs of our Fund, is less than 5% of the size of the mortgage market and thus too small for many institutional investors.
- Aircraft ABS offer higher yields because they “fall in between” the corporate bond market and the mortgage market
- Aggressive financings done in the pre-9/11 era are still paying out cash flows, but have a reduced pool of investors and are trading at discount prices
Sample position: AFT 1999-1A A1 (“Aircraft Finance Trust”)
Aircraft Finance Trust fits our particular style of distressed debt investing since it is an example of a bond with a “broken structure.” The deal originally had five classes, but from today forward none will receive another penny of cash flow except the A1 which we own. Our bond will not receive 100 cents on the dollar in principal either, but since I purchased it at 26 that’s not necessarily a concern. In this situation, it’s not hard to see that the original investors are sellers and outnumber the potential buyers, which is one reason why the price is so low.
A “cash reserve account” in the deal accounts for a third of our purchase price. This account was originally structured into the deal to cover interest payments over periods in which there was not enough cash flow. At new issue in 1999 it was 2% of the deal. Today it is 33%. The servicer will soon release the bulk of this cash to us as a principal payment -- it’s simply not needed now that the deal has amortized down so much.
This bond yields approximately 11% and the range of future outcomes for AFT 1999 is remarkably narrow. In a downside scenario, in which our planes come off lease and are sold for half their appraised value, our return is still approximately 9%. In an upside scenario, where lease rates improve and our jets stay on lease longer than the market expects, our return rises to approximately 13%.
AFT 1999 was once a portfolio of 36 jet aircraft, but 16 years later only eight remain. All are on lease, to six different lessees in six different countries:
- Two Airbus A320-200 jets on lease to Air Canada until January 2019
- One Boeing 737-400 jet on lease to Enter Air until October 2017
- Three Boeing 737-300 jets on lease to Air Italy and PT Sriwijaya until May 2016
- One Boeing 767-300ER jet on lease to TUI Travel Aviation Finance Ltd. until November 2019
- One Boeing 767-300ER jet on lease to Royal Air Maroc until October 2016
- One CFM56-3C1 engine, currently off-lease.
Over the past year two engines and four aircraft were sold out of the trust as they came off lease. The sale proceeds of $17.8mm were distributed to the A1 bond, in addition to the $22.4mm of interest and principal paid to the A1 from lease revenue. Which aircraft, if any, are sold in 2016 will depend on the state of the leasing market when leases expire in May and October, but the sales in 2015 demonstrate that the assets in this trust are being liquidated steadily and capital returned to the bondholder. At the moment the bond is trading at approximately the liquidation value of the aircraft--our return therefore comes from the lease revenue in future. Given that the servicer (GE Capital Aviation Services) values the jets in the trust at 30% higher than where we purchased the bond, our downside is likely to be limited. Over the life of the Fund our return should match or exceed our 11% estimate.
Bonus sample position: “Engine Securitization A” (Acquired after close of 4Q2015)
“Engine Securitization A” was a dream position for the Fund -- hard to track down, safer that most securities in the aircraft ABS universe, and offering above average yields simply because it is unique. I’ve been hunting down this bond like a white whale for two years. Just after the close of this reporting quarter, I managed to buy it for the Fund. “Maintenance spare” jet engines are a niche within a niche and offer compelling economics to the investor. In addition, they allow us to tap a broader pool of lessees. For example, an airline which chooses to purchase all of its aircraft outright might have no interest in the jets we have available to lease, but when one of the jets it owns needs engine maintenance, the airline may find itself leasing one of our spares to keep its full fleet of aircraft in the air producing revenue. This bond has begun returning principal, and I estimate it will yield 12% a year to the Fund. (For the benefit of the Fund and its members I am not identifying this security by name. Contact me if you’d like more information)
Chilmark Air 2017 LLC - Mortgage Backed Securities
Sample position: MALT 2003-3 B4 (MASTR Alternative Loan Trust 2003-3)
MALT 2003-3 B4 is typical of our mortgage bond holdings. Behind this bond are 72 Alt-A mortgage loans made in 2003, 16% of which are delinquent. I expect that during the time we hold this bond around 8% of the loans will default, but since the borrowers have paid down some of their balances and home prices have increased sharply since 2012, losses from these defaults will be small, perhaps small enough not to reach our bond at all. In the meantime, many of the homeowners who are current on their mortgages are selling their homes and prepaying their loans, driving our estimated 15% return on this position.
Sample position: WFMBS 2006-AR14 3A3 (Wells Fargo MBS, Interest Only)
WFMBS 2006-AR14 3A3 is a good example of one of our “Interest-Only” or “IO” holdings. This bond was created when the bankers at Wells Fargo had excess interest left over when creating the rest of the bonds in the WFMBS 2006-AR14 issue. Our 3A3 class was sold as a separate bond, and it amortized down considerably from 2006 until now, when the seller decided to part with it. I purchased it at a discount. In addition to providing the Fund with a double-digit return if mortgage rates stay unchanged, it will provide a much larger return if interest rates increase, because more of the borrowers will hang on to their mortgages rather than refinancing. This positive relationship with interest rates is an important hedge for the Fund against interest rate increases which could happen in the future.
Chilmark Air 2017 LLC - Collateralized Loan Obligations
Sample position: JTWN 2014-4A D (Jamestown CLO IV Ltd)
Jamestown CLO IV is a bond backed by 333 “high yield bank loans” or “leveraged loans” from a diverse group of borrowers such as retail companies (Abercrombie & Fitch, Albertson’s), airlines (American Airlines), gaming (Scientific Games Int’l) and the source of much investor concern, oil & gas (Fieldwood Energy, Paragon Offshore). JTWN 2014-4A D was one of the first of the recently-issued CLOs to fall steeply as the credit cycle turned. It is also likely that it will be one of the first to rise when things improve, which is why I bought it. Nearly 30% of the loans behind our bond would need to default (assuming a 30% loss from each default) for our bond to become impaired, a scenario which would be worse than the 2008 downturn. As it stands today, there is enough loan collateral to cover the value of our bond, and some of the decline in the value of the loan portfolio is due to poor liquidity in the loan market, not anticipated defaults. Because of the cautious tone of the CLO market today, I would not be surprised if the price of this position remains volatile over the period which we own it. However, our return is likely to be in the range of 10% to 15%, depending on changes in the market’s expectation for the losses on these loans.
Chilmark Air 2017 LLC - Exchange-Traded
The exchange-traded products in the Fund are a way of achieving the Fund’s leverage target, or to put it a different way, a method of making sure that our capital is more than fully invested at all times, and that incoming principal and interest payments do not sit idle.
Sample position: AMTGprA (Apollo Residential Mortgage Preferred Stock Series A)
AMTGprA or “Apollo Residential Mortgage Preferred Stock Series A” is a financial obligation of Apollo Residential Mortgage, Inc., a REIT managed by Apollo Global Management, a leading private equity firm. As a preferred shareholder, our ultimate return does not depend on the REIT’s return, only their solvency. This position has an unlevered 9% annual yield, and including leverage it returns a net 14% a year to the Fund.
Chilmark Air 2017 LLC - Investment Objectives for 2016
“Liquidity should be avoided. It comes at a heavy price in the shape of lower returns.” --David Swensen (Yale University Endowment)
For the rest of the year my goal is to round out our Aircraft ABS holdings with several of my favorite Pegasus Aviation bonds, but I’m in no particular rush. Prices have been declining along with most credit fixed income, so it makes sense to let that process continue a bit longer before investing. I’m also on the lookout for one or two more Engine ABS positions since they are one of the best values in the aircraft sector.
I intend to add more CLOs to our portfolio as the corporate credit cycle continues to turn downward. Defaults and losses are of course increasing industry-wide, but in situations where the decline in bond prices gets far ahead of expected future losses it makes sense to invest. In addition there are great variations in the way CLO managers select the loans in their portfolios, and the market does not always price these differences correctly. I’ll be spending time with CLO managers to find out which have been the most conservative before (and during) this downturn.
Chilmark Air 2017 LLC was designed with several unique structural features, and I intend to use these features to give us an added advantage. The Fund doesn’t allow redemptions until December 2017, so there is no need to spend time meeting redemptions or to hold liquid positions to facilitate redemptions. Our holdings are valued quarterly in coordination with EisnerAmper, our auditor, which allows the Fund to hold bonds that are not priced by vendor pricing services. It’s no surprise that these bonds yield more than those covered by the pricing services.
During the year, I will deploy the Fund’s capital at moments when selling pressure intensifies. This approach is no secret, but for many of our competitors it is difficult to execute. In a larger organization sometimes board members or management teams can pressure portfolio managers to stay liquid, or pare back positions right when markets are not functioning well.
Chilmark Air 2017 LLC - Market Comments & Color
In the second half of 2015 redemptions were the main driver of credit markets as investors pulled capital out of hedge funds, mutual funds and ETFs. Multi-strategy funds played a key role in the selloff as many reduced their holdings across the board, marking down both securities with weakening fundamentals as well as those where fundamentals were unchanged or improved. Investment grade and high yield corporate credit fared worst, but asset and mortgage-backed credit declined as well. Lower-rated (BB and B) tranches in the CLO market fell anywhere from 15-30% in 2015, as concerns about the energy sector spread to every sector save for chemicals. Many potential sellers of bonds remain on the sidelines, either hoping for a rebound or distracted by losses in their corporate credit portfolios. The level of pressure on this group of investors is a key to how the credit selloff will continue in 2016. Conditions are ideal for adding bonds to our portfolio, but it pays to be selective since parts of the market have sold off to the widest levels since 2011 and other parts have barely moved at all.
Chilmark Air 2017 LLC - Firm Update
Chilmark Hill will mark its fifth anniversary in April, and while assets under management are still small at $7mm, the firm has roughly doubled in size each year. Since 2011 the firm has returned a cumulative 55% for its clients, showing the power of purchasing fixed income securities at distressed prices. Chilmark Air 2017 represents the first of a handful of funds I will launch in the future, allowing growth to continue at our current pace, at least until our assets approach $200mm. Your client referrals are much appreciated. As a reminder, the Fund is open to new investment in March, and will continue to take investor capital until we reach our target size of $30mm. As always, I am grateful for your investment and support.