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Searching Relative Value in Structured Securities

Oct 22, 2019

River Canyon Total Return Bond Fund

  • AUM

    120 million

  • Inception Date

    Dec 30, 2014

  • Portfolio Holdings

     

  • Portfolio Turnover

     

 

Q: Could you give us a brief overview of the fund?

A: Canyon Partners is an alternative asset manager with about $26.1 billion of assets under management. The assets are primarily invested in a multi-strategy hedge funds, real estate funds and opportunistic distressed debt funds. The main asset classes within the hedge fund include structured products, corporate debt, bank loans, high-yield corporate debt, equities, convertible arbitrage and merger arbitrage strategies. We also have a business focused on emerging markets and a long-only investment strategy, the River Canyon Total Return Bond Fund. 

The River Canyon Total Return Bond Fund is a daily liquidity mutual fund, which concentrates in the public fixed income market, primarily focused on  structured products. I have been at Canyon for 12 years, focusing on structured products like mortgage and asset-backed securities, residential and commercial mortgage-backed securities and other parts of the structured products market. I am a partner at Canyon and Head of Structured Credit investing.  


Q: What differentiates the fund fom its peers?

A: There are four main differentiators that make the fund and the management style unique. First, we are not siloed, which means that we don’t have strong division of labor. It is difficult to ascertain the relative value within the universe at any given point, so our analysts don’t have granular division of labor but work across all the different structured products. For instance, the analyst who works in mortgage-backed securities is also looking at asset-backed securities, student loan securities and other esoteric securities and CLOs. We have a holistic relative value approach and we feel that’s especially valuable in our space. 

The second differentiator is the relative size of the fund, which allows us to be opportunistic and nimble. Currently, the fund has about $116 million in assets under management. Our structured products’ exposure across the firm has previously peaked at around $8 billion and now is about $3 billion, but these assets are in different vehicles and mandates, not in the mutual fund format. We believe that we have the opportunity  to generate a considerable amount of alpha by utilizing our size.

The third point is the breadth of experience and the research approach. At Canyon, we have 40 investment analysts, who have been focusing on different industries and verticals within these industries along the entire capital structure. Within structured products, there are many sectors and securities, which are backed by assets concentrated in those industries. In many large mutual funds there are structured products experts, who focus just on the structures, not on building deep knowledge in the actual asset side of the balance sheet within those securitizations. 

For example, in the case of a shipping and container asset-backed security, we utilize the expertise of our shipping analyst, who evaluates the individual assets in the pool and has deep knowledge of how the economic cycle impacts these assets and what the value drivers on the left side of the balance sheet are. Then comes the structured product expertise on the right side of the balance sheet, which allows us to evaluate the structure and to ascertain the value drivers and the risk/reward. It is often difficult to properly narrow down the risk-reward, so we feel that our approach helps to avoid some landmines and to take advantage of mispriced opportunities.

The fourth differentiator is the system that we utilize to select the securities. Although we use data sources and third-party analytics, we have developed proprietary, custom-built system overlays. That system helps us to distill information and it ultimately drives the security selection by narrowing down the number of securities that undergo additional analysis. . We are not a black-box type of investor; we use tools that help us synthesize the data and distill it down to an investable universe. That’s how we inform our security selection to the best extent possible.

Q: What core beliefs drive your investment philosophy?

A: Our philosophy is driven by a bottom up, research-driven, value-oriented approach. We focus on downside protection and on looking for “free and cheap” upside. While we are not a top-down asset allocator and we have a bottom-up, security-by-security portfolio construction approach, we also believe that we need diversification. Our goal is to achieve staying power across different interest rate environments and economic cycles.
 
We don’t bet on specific macro outcomes, such as the direction of interest rates or the economy. Instead, we aim to pick the securities, which have staying power and deliver acceptable return across a wide range of outcomes, including higher or lower rates, inverted or steep term structure, recession or economic expansion. Overall, we aim to construct the basic principles of staying power across a variety of economic outcomes while preserving optionality in times of volatility in either direction.

Obviously, it is difficult to forecast positive returns in all possible scenarios, but on a relative basis, we believe we can construct portfolios that hold their own in poor times and certainly do well over an interest rate or an economic cycle.
 
Q: What are the critical steps of your investment process?

A: We literally see hundreds of line items per day. These are potential investments in structured products across different sectors and asset types, such as mortgage-backed securities, commercial mortgage-backed securities, credit card receivables?, student loans, esoteric [what?], etc. That’s a lot of information to distill down and it takes a tremendous amount of analysis and time, so we have developed real-time algorithms and models based on the security and collateral types. 

We find opportunities through various channels and our system is designed to distill that information in an adjustable and efficient manner. The algorithms look for certain characteristics for each security and collateral type. Our goal is downside protection and making sure that we receive our principal and income in a total return framework. A key aspect is the payback and being able to withstand a variety of different economic outcomes.

We screen for these characteristics by stress testing the securities through a lot of scenarios with different interest rates, default rates, or recovery rates. Ultimately, we narrow down the big universe of opportunities to the securities that provide the best risk/reward in our view. 

In the next step, we take these securities and run each of them through other quantitative analyses. We have a hands-on approach that involves qualitative aspects as well. It’s not a necessarily quantifiable or an algorithmic approach. The human capital element is the last part of the value-added process, where we pick the actual securities and populate the portfolio.

Q: How do you approach allocation in structured products?

A: The allocations are not preset. We don’t try to allocate between sectors from a top-down perspective and then populate each individual bucket. Instead, we rely on a bottom-up approach, while also believing in diversification. Each security has its own merit to be in the portfolio, but we don’t prefill allocations, because we see a lot of data and offerings. Internally, we have a high conviction set of relative value opportunities within structured products. 

For example, if we feel that CLO AAAs offer attractive risk/reward for this mandate, then many of the securities that we distill down at any given day naturally are those CLO AAAs. We don’t tell our systems what we like, but we inform our opinion and preference by the relative value that we see in the market at any given point. However, we are mindful of the concentration risk and the importance of diversification. Although we might believe that CLO senior liabilities represent the best risk-reward in the market at the time, we wouldn’t concentrate the portfolio entirely in those securities.

Q: Do you rely on internal or external ratings to determine the merits of individual securities? What goes in the due diligence of each security?

A: We don’t assign internal alternative ratings and we don’t invest based on ratings. We wouldn’t assume a guaranteed price principal of a security just because of its BBB rating, for example. In fact, many BBB securities in the current market are likely to incur principal loss at some point. So, we are not a ratings-based buyer. Since inception the fund has maintained an average credit quality rating of investment grade rating and currently has A+ average credit rating. [

The securities that we select go through a large funneling process, where we narrow down the universe to a few attractive securities. The securities that make the preliminary and the final cut have attractive risk-reward. The next step of the analytical process for each security involves detailed collateral inspection regarding geographies, cycle buckets, LTV buckets, historical information, modification analysis, and projected rates based on modification analysis.

Then for each individual security we run about 500 to 700 scenarios, which are based on prepayment rate, default rate, recovery rates, modification rates and balance recovery rates. We perform a myriad of different stress tests to ensure that the downside is protected and to determine the possible pricing in different macro environments. If home prices go up or down 10% or 20%, where is the market’s base case going with respect to defaults, recoveries or prepayment? Overall, forecasting and evaluating across different scenarios informs us how resilient these structures might be. That analysis enables us to more accurately gauge the upside and the downside.

Q: How is the research team organized? Who makes the final decision about the securities in the portfolio?

A: I am the senior portfolio manager for the fund. Alex Siroky, a senior analyst with the firm, helps with the day-to-day investment screening process and trade recommendations. We come up with ideas about sectors, markets or securities ourselves or through our  analytical tools. We have an investment committee, where the portfolio managers decide which securities go into the portfolio through our rigorous selection process. The final decision about the portfolio holdings is ultimately made by the senior portfolio manager.

Regarding the research team, we draw resources from the entire Canyon platform. That platform represents a large symbiotic organism, which can leverage someone’s expertise in shipping or aircraft securitizations or the left side of the balance sheet. For example, the entire CLO group buying CLO liabilities obviously has good insight and expertise regarding CLO liabilities and structuring and good visibility into the underlying loans on the left side of the balance sheet. Our research process is being informed by the entire credit analyst team, which consists of over? 40 credit analysts. Being able to evaluate both sides of the balance sheet is crucial for our investment thesis. I believe it is a central advantage to the way we invest.

Q: What are the key elements of the portfolio construction process? Do you impose limits on the sizes of sectors or positions?

A: The portfolio is built security by security. However, we avoid overconcentration in any sector or security, regardless of how resilient we believe they are, because we appreciate the diversification benefit. We make individual security bets as opposed to one big bet in the portfolio. That goes back to our strategy of investing in securities that are resilient across a wide range of macroeconomic outcomes. 

In a nutshell, we aim to outperform with our security selection, not with allocation to macro factors, so we manage a diversified portfolio of small bets. The inherent benefit of structured products is the higher diversification, especially with larger size. While in the corporate universe names are finite, in structured products each individual trust is its own name, backed by distinct collateral. 

Our benchmark is the Bloomberg Barclays US Aggregate Bond Index.

Q: What is your sell discipline?

A: That’s an ongoing daily consideration. These investments are daily liquidity vehicles, so we treat our portfolio as a set of offerings. We see hundreds of securities per day and the consideration of our existing portfolio also goes into that list. If we see alternatives that dominate the risk-reward, we would sell. If there is a “big sea” change in the underlying facts regarding collateral performance or an overwhelming multi-standard deviation macro event that changes the core thesis of the securities that we own, we will certainly evaluate that. But every day the securities in the portfolios compete with everything else that’s out there.

Q: How do you define and manage risk?

A: There are different types of risks. For a portfolio like ours, the primary risks are credit and interest rate risks. There is convexity risk, which is related to the maximum price of a security in times of lower interest rates. Other risks include prepayment risk, default risk and consumer behavior risk, which are all related to the credit risk. 

While there are many different risks to consider, the different securities certainly don’t exhibit all of them. For example, agency MBS is not a credit risk instrument, but it has duration, convexity and prepayment risk. We need to manage all these risks at the individual security level and the portfolio level. 

The focus on downside protection and staying power during interest rate and economic changes is paramount to our portfolio construction. Risk is also important to us in the context of reward. Inherently, this is a higher-quality, lower-volatility mandate, so we don’t buy highly levered securities with 100% upside and 100% downside. Again, our security selection informs our portfolio construction and our risk management.

Q: Does the negative rate environment impact the way your select securities?

A: No, because the level of interest rates is generally irrelevant to our security selection and portfolio construction. The fund is based on relative value and downside protection, regardless of which way interest rates or credit cycles might turn. Rates may be 10% or 0%, but our next move wouldn’t be guessing their direction. 

We would still focus on the same principles of portfolio construction that we expect to isolate the portfolio from being exposed in either direction.

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