Odd Lots - What It's Like to Suddenly Become a Bond Manager in the Credit Crisis

Episode Date: July 24, 2017

We talk a lot on Odd Lots about the idea of investing. But what's it like to actually have to put money to work in some of the trickiest investing environments in history? David Schawel was an equity analyst who suddenly became the manager of a portfolio of subprime mortgage bonds during the worst of the credit crunch. Now he manages fixed-income portfolios for New River Investments. We talk to him about what it was like to manage a subprime portfolio back in 2008, the differences between stocks and bonds, and how to put money to work when lots of people are talking about an overvalued market. See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa, play the Odd Lots podcast on Amazon Music. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top-grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor.

Hello and welcome to another edition of the Odd Lots Pothouse podcast. I'm Tracy Alloway. And I'm Joe Wisenthal. So Joe, you and I talk a lot about markets, but it's kind of weird, I guess, because like neither of us, well, I suppose you have, you invested a little bit when you were in college, right? Way back of the day, I did a little bit of trading. And I worked for a brief period for portfolio management company.

But no, I would say that between the two of us, we do not have a lot of collective experience actually in the market. Right. So have you ever wanted to have an in-depth discussion with someone who actually makes investment decisions on a daily basis? Yes. This is all. I mean, to be honest, this is all I want to do every day. You know, there's so many people who just talk and talk and pundits and strategists and people who tweet too much. and it's like, forget all the noise. Let's just talk to someone who, you know, actually has to put money to work. I mean, that's what people really want to hear, right? Right. And, of course, it's one thing for us to kind of sit back and say markets look frothy and this is over-valued.

There's signs of irrational exuberance. But if you're someone whose job is to actually put money to work, you have to find something to invest in, right? Exactly. Or, I mean, or theoretically you could sit out the market, but then you're going to be judged on that question too, but you definitely can't get away with just saying boring stuff like the markets are looking frothy and all the boring stuff people say all the time. But anyway, why are you, what are you getting at? Are we going to have such a conversation like that today?

Are we going to have a good conversation? Yeah, we are actually. So today, for our guest, we have one of my favorite investment managers, actually. It's David Shawl. He's a portfolio manager over at New River Investment. You've had him on your show a couple times. He's a prolific tweeter, actually, but he is also someone who makes money do things on a day-to-day basis. So unlike our conversations, we're not talking to a poker player, we're not talking to a gambler, we're actually going to talk to someone who invests. A real-life credit portfolio manager. That's who we're talking to.

Awesome. Well, he's in studio right now. Hey, David. Hey, guys. Thanks for having me on. Shall we start with, well, why don't we back up a bit? Why don't you tell us what exactly you do and what kind of portfolios you manage? Sure. So I started at New River about two years ago, and right now I manage an opportunistic income strategy. And pretty much what that does is it focuses on fixed income or fixed income like securities in the publicly traded space.

So these are instruments such as mortgage reeds, reeds, closed-end funds that have underlying bonds in them, preferred stocks, business development companies. And it's kind of a niche area of the market where few players play. It's very illiquid. And it's a little bit of the Wild West in the market, you know, versus before. I want to ask a question that backs up even farther than that, because the idea of having a job where you can, and take money and buy stuff and sell stuff seems pretty appealing. But how do you even get there? So how did you get to this role in life where you work for New River investments and you have this money to invest? What's the path to get there? Sure. So that's a great question. So I started at a bank, De Novo Bank, called Square One Financial in early 2008. And I started as a credit

analyst. And Square One was a commercial bank, but they catered to the venture capital community. So a company would raise $10 million of the Series A, and they might raise a little bit of debt to bridge them to the next equity round. And we'd make the clients keep all their deposits at the bank, and pretty much I was underwriting these clients. So it might be a formula line of credit. And so it was early 2008, and the bank at the time had an outsource investment manager who had loaded them up to the gills in subprime bonds. And the CEO came to me and he said, hey, David, I heard you worked on Wall Street. And so I just moved back from New York. I was in equity research. So I wasn't in fixed income at all. And he said, hey, I heard you work on Wall Street. We need your help.

I said, sure, with what? And he said, we've got a whole portfolio of subprime bonds that are going bad. And we don't know what to do. So we need your help. I said, that sounds really interesting, but I don't know fixed income at all. Just that minor detail. Yeah, just that minor detail. I said, you know, I've done the CFA program and that's kind of all theory and no practice. And he's like, doesn't matter.

We need you to come over here. So I went over there. It was, you know, early 2008, and we had probably a portfolio of 500 million of bonds that were going bad. And I remember looking at one of the mark-to-market reports, and I think it was a negative 135 million in mark to market and the bank only had equity of 120.

So we were well insolvent on paper. And they fired the investment manager. The treasurer at the time that was running the portfolio quit. So I was left at the time in the middle of the crisis to run cash flows, read prospectuses, model cash flows, kind of figure out, you know, the mess that we were in. And so, you know, I had to meet with regulators and I'll never forget one of the regulators coming in from the FDIC or Federal Reserve. I don't remember which one it was.

And they opened up a intro to mortgage-backed securities book. So at that moment, I realized that, you know, even they didn't know what was going on. And so, I mean, it was fascinating. I remember, you know, just looking into these bonds and seeing some bonds that were bought where, you know, they decided to pick up an extra 30 basis points of spread by going from the senior A1 class to the mezzanine tranche. and I looked at, you know, these bonds were six months old, and already 25% of them had not even made one payment. Not even one payment.

So, you know, that's how I learned fixed income. I was kind of self-taught in a lot of ways. So the portfolio that I managed there was kind of a wide range of-should. So you're thrown right in the deep end. The stone right in the deep end. We ended up raising capital to recap ourselves. But the portfolio I ended up managing was kind of a mix of mortgage-backed securities, corporate bonds, preferred stocks, municipal bonds, asset-backed securities. So kind of the kitchen sink of fixed income, kind of with the only two constraints being, you know, we had to keep the duration around three-ish or lower.

And we probably could only have about half the portfolio in credit. From there, it was kind of my job. And I had a lot of flexibility and freedom to kind of be creative and set the portfolio up however I wanted. So if I wanted, you know, 100% of the portfolio in three-year bonds, I could do that. if I wanted some in 30-year bonds and some at the front end of the curve, I could do that. And that's kind of the fun part is, you know, taking different types of securities with different characteristics of credit, duration, embedded leverage, and creating a portfolio that will perform in the types of scenarios that you're looking forward to.

So, David, that kind of leads into the question I wanted to ask, which is, yes, you've got into fixed income in 2008, which was definitely a special time to be doing it. And to some extent, everyone was learning new things to put it mildly during the financial crisis. But you came from an equity background. So what struck you as the biggest difference between equities and fixed income when it comes to investing or analyzing portfolios? Good question. Well, I think the macro component. So, you know, so much is driven by interest rates, obviously.

So, you know, obviously, you know, key characteristic of fixed income is duration. So just how interest rates... For our listeners who don't know the definition of duration, what does that mean? So duration would be the first derivative. So it would be the change in price for a given move in interest rates. So if interest rates move X, the duration will tell you how much the underlying asset will move. Correct. So in theory, if somebody said duration was three in rates went up 100 basis points,

you know, the price would decline 3%. Got it. And vice versa. All right. So I interrupted you and you were... or talking about the difference between equity and fixed income investing. Yeah, so obviously I think the macro implication. So, you know, implication of federal reserve policy, inflation, you know, other central

banks throughout the world, and then just broadly credit cycles. I mean, credit cycles are a lot different than, you know, equities, obviously. So, you know, there's different types of supply. There's market technicals. Is the goal different? Because when I think of my biases, when I think of an equity man, I think of someone who's really thinking about the upside and beating the indices. And when I think about a fixed income manager, I'm thinking of someone who's more about

downside avoidances and you sort of know how much you could make, but you're trying to limit the potential losses. Is that a fair characterization of the risk profile or is that not thinking about it the right way? I think it is because at the end of the day, you know, your upside is you get your principal back and you get paid interest too. So, you know, so you're right. The risk reward is very different in, you know, fixed income as it is in equities. So, you know, if you have a zero in fixed income, you know, you might not have the two X like you'd have in equities to offset that. So, you know, your risk reward's a lot different. But what about your benchmarks or I guess what I'm asking is what sort of return profile are you aiming for? And you must be pegging yourself or benchmarking yourself to a particular thing or goal, right? Correct. So, you know, when it was at the bank, it was more of an asset liability framework and more kind of in terms of the Barclays ag. Now the Bloomberg Barkley is. Now the Bloomberg Barkley's Act just so that we stay on. Well done, Joe. Joe's totally on message. That's right. So I think, you know, for people that are not familiar, I would kind of call it the S&P 500 of the bond world. And that's pretty heavily weighted in treasuries and corporate bonds. So I would say in agency mortgage-backed security. So those are the

the main components to the Barclays Ag, kind of intermediate, intermediate benchmark, you know, average life and duration, you know, in the five-ish range. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard.

At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio.

All investing is subject to risk vanguard marketing corporation distributor. Now, I want to talk about the market right now. But before we get there, let's see the next step. So you have this portfolio. How do you find what to invest in? Where do you start? Let's say someone, let's just imagine a blank slate. Let's say you had a billion dollars to invest. It wasn't invested anywhere or whatever it is or you have a portfolio that's totally messed up and you need to fix it. Where does the process begin to find investments that are, a good or B, sort of suit the needs of whoever's money it is. Right. So I think the first question would be, is this an open-ended return where you're shooting for absolute return or total return, or is this an asset liability framework? Asset liability framework would be, you know, for instance, a bank or insurance company that has certain types of liabilities do in the future, and you're trying to match those. So from that point of view, your investment process is very different because you're trying to meet, you know, certain liabilities in the future, whereas kind of

of an open-ended total return, you know, kind of more like I'm doing right now, you know, you're not trying to meet any liabilities in particular. So I think, you know, what I tell people is kind of there's four ways to make money in fixed income. There's kind of like four drivers. You know, first is duration. So you can take, you know, more or less duration, you know, going longer on the curve. There's credit risk. So, you know, you can go down in credit. You can buy triple C bonds instead of double B or AAA. The next is liquidity. So you can kind of go down the liquidity spectrum.

You know, some, you know, the PIMPCOs of the world or double lines might need to buy, you know, much larger issues. Whereas a smaller investment managers can buy these small issues or just kind of off the run things. And then the fourth is leverage. And that's either leverage that you could use, you know, through repo or embedded leverage through, you know, certain kinds of securities that have leverage within it. So anytime you're shooting for more return or more yield in the market, really you're taking one or more of those four components. And I think the big thing when looking to foreign portfolios is you're looking to say at the current time, which of those four aspects is most attractive? Interesting. And there are certain times when it's, you know,

duration. So after, you know, Trump was elected and rates kind of sold off, you know, a lot of things in duration, you know, really sold off hard and things tied to the long end such as municipal bonds and preferred stocks, you know, you know, some things tied to those really got hit hard. And there was opportunities. And, you know, there's other times when it's really credit. So say early in, you know, 2016 when we had the oil scare and the high yield blow out and, you know, spread and much lower rated bonds were far more attractive. So, David, I want to ask you about the current market, because amidst all the talk about, you know, lofty valuations and froth in the market, credit and, you know, things like corporate

bonds, high-yield bonds, those sold by junk-rated companies, subprime auto ABS, even some consumer loan ABS or securitizations, those have all been name-checked as potentially risky forms of investment in the current environment, or at least overvalued in terms of what investors are getting back for putting their money in those. How do you make investment decisions when everyone is basically talking about things being overvalued in the market? Yeah, it's a great question. I think one thing is just to remind yourself that, you know, for how many years now have people been saying that? So, you know, the mere fact that that's being commented on doesn't necessarily mean that's, you know, it may be true, but it may also

continue. And that's not to say, you know, we're going to ignore risks in the market. But like you guys kind of alluded to in the introduction, if you're tasked with managing money, you can't really just sit it out and say, you know, maybe you can't in your personal account. But if you're managing assets, you can't really say, I'm going to set this whole thing out. So I think it's looking at the different risks. For instance, um, you know, do you think that the risk return of, you know, corporate issuers is more favorable than, for instance, housing-related debt, which I think, you know, the last crisis was housing-related debt, but I think that the fundamentals for housing-related debt at this time are actually pretty

favorable. You know, consumer balance sheets are being repaired. Um, you know, there's really not non-agency being issued, you know, if there is very, very little. Um, so, you know, in my mind, something like the underlying tailwinds and fundamentals of housing-related debt are a lot more attractive than, you know, corporates, for instance. You know, but you can't, you know, just stop there because, you know, the market may already be pricing in that. So I think a big thing that you look at in the bond market is loss-adjusted yield. So you're not just looking at the yields and spreads you're getting, but you're having to loss adjust that. So you're looking at different scenarios and saying, well, if the credit cycle is benign in defaults here run at X, you know, what does

my return look like? But, you know, if it's very unfavorable, then what will it look like? Because I think, you know, you have to have humility in this job and say what I think is going to happen is probably not going to happen. So we're going to look at various scenarios. And we're going to say in rates up, X happens. In base scenario, you know, Y happens and rates down Z happens or in, you know, benign credit cycle this, you know, great credit cycle that or terrible credit cycle, you know, something else. So you're looking at different scenario analysis and, you know, sometimes not all bonds are going to win for you at the same time. So for instance, at the bank, you know, one of the things I did was I was very long in zero coupon California school district

munis. And it sounds crazy. And in isolation, people might not have bought them because they 30-year zero coupon bonds. But they had very, very widespread and very good risk rewards. And when you mix that with things that were very short at the time, it created a very favorable overall dynamic. So I think one of the things is you can have a bond in isolation that might look ugly or it might look unfavorable. But when you add it into a portfolio, you know, you can create superior overall profiles. And I think that's the fun of it. You're mixing different ingredients in in trying to create a profile that will match what your overall assessment of the market is. Well, David Shaw, I think that was a, I love that last answer. I love that it ended on a 30-year

California school district zero coupon bonds because probably an area of the market that not many people have perhaps ever thought about in their entire life. But I think that was a great talking to you. like sort of a great explanation of what you do. And then also I love, real quickly, name those four things again, the four vectors through which there are opportunities in fixed income. Correct. So that's duration. Right. Sensitivity to raids. Credit risk. Liquidity risk. And leverage. Great stuff. David Shaw, portfolio manager at New River Investments. Thank you very much for joining us. Thanks, guys. So, Joe, are you thinking of changing jobs? I am going to switch jobs and put all of my money in, I think, 30-year California is zero.

No, I think that was the old trade. I imagine that opportunity is not there anymore, especially by the time people hear this podcast. I have to admit, it does sound really fun. He said it was, he said that use the word fun at the end, the idea of actually having money on the line, not just talking. There was this gigantic world of fixed income, trying to find the diamond in the rough. you got to admit, it sounds like it would be a pretty cool job. It sounds pretty frustrating to me, actually, just because there are so many, there are so many factors to consider.

And I guess I'm a risk-averse kind of person. So I would sit down and I would look at a particular bond and I would just basically list off all the things that could go wrong. And I'd probably never invest in anything. And I'd be beaten by all my peers. And I would be very, very bad at this. Yeah, I know exactly what you're saying. I think the journalist mindset is to focus on the downside.

probably a good reason why we're in our current jobs and not David's job. Yeah, you're right. All right. Well, I feel better. So should we leave it there? I'm Tracy Allaway. You can follow me on Twitter at Tracy Allaway. And I'm Joe Wisenthall. You can follow me on Twitter at the stalwart. And you can follow David Shaw on Twitter at David Shawl. And our producer Sarah Patterson, Sarah Pat with two T's. Thanks for listening. The news doesn't stop. on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra. Join us every Saturday and Sunday for the new Bloomberg this weekend.

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