I recently sat down with Don Quigley who has been the co-manager of the Artio Total Return Bond Fund for over a decade. The fund is rated 4 stars (out of five) by both LB Ratings and Morningstar. For the last 10 years the fund has beaten the Barclays US Aggregate Bond Index by over a full percentage point per year (on average after fees). Around 10% of the portfolio was invested in Commercial Mortgage Backed Securities (CMBS) at the time of this article.
Before we get to the interview, let me give you some background on CMBS:
Most core bond funds have a large portion of their portfolio invested in agency Residential Mortgage Backed Securities (home mortgages) or RMBS for short. There are several great reasons to invest in these securities. They are backed against default risk, directly or implicitly, by the US Government, and pay a higher yield than Treasuries with a comparable duration.
However, RMBS are not the only type of Mortgage Backed Securities. The development of office complexes, strip malls, factories and self-storage centers can all be financed by mortgages. These mortgages are called Commercial Mortgage Backed Securities (CMBS). They are not backed by the US Government and are very different than RMBS.
Most core bond mutual funds have a very small portion of their portfolio invested in CMBS, as they tend not to make asset allocations that are very different than the index which they are measured against. The index that most core bonds follow, the Barclays US Aggregate Bond Index, only has around 3% of its holdings in CMBS. I wanted to speak with a manager of a major bond fund that held more CMBS than the index, and Don Quigley was kind enough to sit down with me.
Here is the Interview:
Learn Bonds: I saw a chart which showed triple A rated CMBS pay about 2.5% more than than treasuries. Is this true?
Don Quigley: True, but a triple A rating is not very meaningful for CMBS. While credit ratings can be very useful when looking at corporate or municipal bonds, they are generally not useful when looking at structured products like CMBS. If you looked at the yields of the AAA bonds that were used to calculate the 250 basis point spread, I think you would find that the range was from 80 to 400 bps. Artio does all of its own CMBS credit analysis, and does not rely on ratings.
LB: What makes CMBS an attractive investment for Artio?
Don Quigley: Rock-solid credit and high relative value. However, I should note that we have started to sell-off some of our CMBS position. A year ago, maybe 13 or 14% percent of our portfolio was invested in CMBS. However, as the spreads over treasuries on our positions have narrowed to 100 bps (1%) we have started to take profits. The question for us in any position is are there better investment opportunities.
In general, the property owner has skin in the game and would take a loss before the holders of CMBS. In recently issued CMBS, the LTV is 64%. That means the value of the loan is 64% of the value of the property which serves as the collateral for the loan. This provides tremendous protection. Additionally, there is subordinated debt. The loan is divided into tranches (pieces), and certain tranches will be the first to absorb losses on CMBS. By selectively buying certain tranches, you can have a buffer against losses, where other bondholders would absorb the first 10%, 20%, or even 30% of losses on the CMBS.
LB: Sounds very safe. Are there major risks associated with CMBS? For example, like pre-payment risk on RMBS?
Don Quigley: While some pre-payments do occur, this is not a major risk for CMBS. Refinancing is the biggest risk. Typically, a CMBS will pay down some principal over time, however around 60% will need to be refinanced at maturity. This was a major problem in 2008 – 2009 when credit markets froze up. However, the refinancing of CMBS is currently happening routinely in the market.
LB: How do CMBS react to interest rates?
Don Quigley: A CMBS with a 10 year maturity might have a mathematical duration of 7 years. However, if interest rates rise due to economic conditions, a CMBS might lose less value than a treasury bond with a duration of 7, as the credit spread might come down. There would be less re-financing risk and the properties in CMBS might be able to command higher rents, generating more revenues.
LB: Thanks for the interview. We have focused on CMBS. However, that is only a small portion of your portfolio. Is there any investment thoughts that you would like to share with our readers?
Don Quigley: I wouldn’t be buying Treasury bonds at this time, but would instead look to own other types of bonds with greater yields. Positioning yourself in corporate bonds of well run companies allows you to gain more, without an uncomfortable jump in risk. We also think there are advantages to owning the bonds of a few different countries, such as Brazil and Mexico. We believe you are able to get a better risk adjusted return expectation than you would just holding US Treasury debt.