The Education Of A Mortgage Bond Manager, Part X (The End)

Personally, I did not have an outline when I began this series. If I had decided to create a “story arc” it would ended with part six, which led to my becoming the corporate bond manager, but I will end this series on a different note, and with different lessons.

1) After the merger, post 9/11, we decided on heresy. We were going to sell a large amount of the CMBS I had acquired over the prior three years for a large capital gain, and redeploy it into the bonds of hotels, airline EETCs, and every other area negatively affected by 9/11. We did a huge down in credit trade.

As far as mortgage bonds went, the sale was a stunning success. The execution levels for the sales were great, and what we reinvested in were areas of the market that were dramatically oversold. What could be better? (A client who knew how use the results would be better.)

2) One day in 2000, the client came to me and said, “We’d like to do a bond indexed annuity.” After reviewing product design, which allowed holders a one time option to increase their rate over the term of the annuity, and doing a little bit of game theory work, I said, “Here’s the good news: given what we know about policyholder behavior and what we know about bonds, this is a cinch to hedge.” As I explained the dynamics to them they realized the risks were minimal, and they decided to proceed ahead. Sadly, the product was not attractive enough, and it was killed. Equity products got attention in that era, not income products.

3) In 2002, when I was a corporate bond manager, I had to do what a mortgage bond manager does on occasion: read thick prospectuses. Bear markets in credit often offer the most interesting deals — as an example, the Prudential “C” bonds. In this case I had to read through the prospectus of a Dominion subsidiary that had an Enron-like financing structure post-Enron. If Dominion’s credit was downgraded, and its stock traded below a certain level for a certain number of days, the bonds would have to be redeemed at par-plus through an issuance of preferred stock.

We became one of the larger holders of those bonds. Enron-like structures are good for bondholders if they are a small part of the capital structure. They are bad if they are big, because you can’t protect everything.

We bought the bonds at a significant discount to par for a 3-year bond. Our research showed that Dominion the parent company was on the hook. The larger holders negotiated (we were in the top 10), and eventually the bonds were tendered for a 10%+ gain, plus 7% of carry over the less than one year period. I ended up sharing the the experience in real time with Cramer, who wrote a post about it in the midst of the furor. Yes, bond markets can affect stock markets, and vice-versa.

4) There was a large debate in that era over what to do about Qwest / US West. Amid corporate troubles, there was one easy play — buy long-dated US West bonds. We all agreed on that. But should we own Qwest bonds? That was harder.

But then one day, because of our high yield contacts, we came into contact with the offering documents of a Qwest subsidiary, which had done badly. It was a private placement, so when we inquired about it they asked for our documents, and we faxed a copy to them, though we had not been on the original deal (good thing).

As it was the debt was trading at under 50 cents on the dollar. As I read through the prospectus, I realized that the debt was guaranteed by Qwest. Given the short term of the debt, it made sense to trade our lower yielding Qwest positions for it.

And what did we do? Nothing. What happened to the debt two years later? It was paid off at par. To misphrase Mr T., “I hate it when a plan doesn’t come together!” (I am certain that comment dates me.)

5) (the end of the end) While I was the less-restricted manager of bond assets, both corporate and mortgage, for my client, I would sometimes meet with my former boss for lunch. I would tell him what I was doing, and he would say, “Don’t you realize the risks you are taking?” I would tell him, “Yes, but I have to evaluate risk and return relative to the other risks and returns available elsewhere in the market. You have to pick the best of them.”

One thing I do know, I was far more willing to accept bond market risk than my boss, who had a strong teaching in the 90s, prior to hiring me, a neophyte.

There are two odd things here: why should an actuary turned bond manager take risk to make money amid panic? Because he learned to be contrarian — this is something that must be experienced in order to teach it. Second, why should I do far better than the guy who taught me? I was more willing to take risk when it seemed to be rewarded. Don’t get me wrong, when spreads and yields are narrow, I am not there. I don’t take uncompensated risks.

There is wisdom in trying to understand the credit cycle. It is one of the few constants in terms of economics. If you follow credit, you will understand the economy in the short run. If you follow the credit cycle, you will invest better than most.