Hedge Fund Finds Asset-Backed Bargains in Subprime Debris


Swooping into sectors left cratered by the global financial crisis, hedge funds have found that the surest bets in recent years are in mortgages and other asset-backed securities.

Greg Richter, who co-manages the $950 million Candlewood Structured Credit Fund, says the reason lies in the mix of return and risk in securitized debt, Bloomberg Markets magazine will report in its July/August issue.

“Some of it’s the opportunity, the beta,” Richter says.

The asset-backed-securities market offers yields of about 8 percent, he says. Much of the rest of the fixed-income world is providing less return.

Results from the Bloomberg Active Indices for Funds, which aggregate return and risk data by strategy, back up his point.

The top-performing hedge-fund strategy from January 2011 through May 2014 was investing in mortgage-backed securities, with a total asset-weighted return of 54 percent. Mortgage-backed was followed by the asset-backed category, with a gain of 46 percent. That’s not all: The two strategies registered the smallest monthly losses, the lowest proportions of down periods and the highest Sharpe ratios, which measure risk-adjusted performance.

The Candlewood Structured Credit Fund, which Richter oversees with co-manager Brian Herr, returned a cumulative 80 percent over the period. Its only down month since its inception in January 2011 was June 2013, when the fund recorded a 1.6 percent dip, according to company data.

Credit Suisse Roots

New York–based Candlewood Investment Group LP traces its roots to a credit hedge fund started within Credit Suisse Group AG. The fund was spun out in 2010 and now oversees $2.8 billion in assets. Of that total, about $1.5 billion is invested in two structured-credit funds managed by Richter and Herr. The rest is focused on event-driven and distressed corporate credit strategies, including the Candlewood Special Situations Fund.

Candlewood’s structured-credit investments are spread across a dozen niches of the market, including bonds backed by aircraft operating leases, student debt, subprime mortgages and collateralized debt obligations, Richter says.

“We’re constantly searching for what we believe to be undervalued CUSIPs,” he says, referring to the identification numbers assigned to bonds. The managers look to resell what they find to buyers who value the bonds differently, on average turning over more than 20 percent of the fund’s portfolio each month.

“We’ve got a lot of trading DNA,” Richter says.

Returns Persist

Relatively high returns persist in the securitized market because, for one thing, many bonds have low credit ratings.

“What we have is a lot of triple-C- and D-rated securities because the rating agencies are still trying to rate the return of principal at par,” Richter says. “It keeps a lot of the deep-pocketed investment-grade buyers out of our market and allows us to trade at still-attractive yields.”

Candlewood has no illusion that it will receive 100 cents on the dollar for the bonds it buys.

“We’re buying these securities at 50; we want to get 70 back,” Richter says.

The labyrinth of the securitized-debt market is a barrier to entry for competitors.

“There’s so much information, so much innovation, so much structural complexity, so many different credit enhancements that have been used in these different sectors,” he says.

Another obstacle is sourcing bonds, according to Herr.

“If you haven’t historically been involved in some of these markets, it gets tougher to leap in,” he says.

The upshot, Richter says, is that in contrast to the corporate bond market, “there are mispriced cash flows left and right.”

Largest Holdings

The fund’s largest holdings as of April were in nonagency, subprime mortgage-backed securities, which accounted for 29 percent of its portfolio. The next-biggest sectors were aircraft-related debt, at 14 percent, and commercial mortgage-backed securities, also at 14 percent.

Each subsector has its peculiarities, Herr says. One holding is aircraft bonds issued before the Sept. 11, 2001, attacks on the World Trade Center and Pentagon. Airlines often don’t own the planes they use, choosing instead to lease them from special-purpose vehicles that buy them with funds raised in bond sales. In the wake of Sept. 11, such bonds plunged to as low as 75 cents on the dollar as lease rates were cut by a third.

“A lot of planes were parked in the desert,” Richter says. “The deals in essence blew up in 2002 and 2003.”

Aircraft Valuation

Another complication for the securities is how the valuation of an aircraft changes as it ages.

“Oil prices are one of the things that can really move the value of these planes because the older ones tend not to be as fuel-efficient as the newer ones,” Richter says.

Airplanes can also throw off cash when they go out of service and get sold off for parts, he says. Aircraft bonds and other asset-backed securities differ from corporate junk bonds in that way, Richter says.

“They are amortizing, self-liquidating securities,” he says. By contrast, getting paid back on a junk bond often depends on refinancing. A high-yield issuer needs to remain leveraged to function, Richter says.

“Our deals naturally delever; the payments from the underlying loans or leases are captured in the trust to pay down debt,” he says. “They don’t need a capital markets event to pay you back.”

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