The Billion Dollar Interview with Paul Heyrman, ABS Product Specialist at CQS Asset Backed Securities Fund

CQS is a multi strategy asset management firm with US$12.6 billion of assets. The business was founded by Sir Michael Hintze in 1999. CSFB seeded the launch of their first fund in March 2000 and they have since expanded to include additional strategies and bespoke solutions in the areas of multi-strategy, convertibles, asset backed securities, credit, loans and equities. CQS has always placed fundamental analysis at the heart of their investment process and looks across companies’ entire enterprise value – debt and equity – to assess relative value across a corporate’s capital structure. CQS takes a team-based approach seeking interconnectivity across all areas in which they invest credit, equity and their derivatives. As active managers; CQS is not afraid of taking risk appropriate to a particular mandate. CQS believes robust operations and risk management platforms provide all mandates with liquidity management and risk monitoring which should enable their investment professionals to be more nimble and effective throughout all market environments. Paul Heyrman, their ABS Product Specialist shares the strategies, expansion of the fund, its portfolio allocation and annual returns.

While CQS is London-based, they have had a Hong Kong presence since 2005 and are regulated by the FCA in the UK, the SFC in Hong Kong, ASIC in Australia and registered by the SEC in the US.

Eurekahedge: Your fund portfolio boasts an impressive range of ABS instruments, from Euro RMBS to student loans. How do you observe all this space for mispricing opportunities and decide on your portfolio allocation?

We analyse the ABS sector by combining both quantitative and qualitative measures. Our team has a wealth of diverse investing experience across ABS sectors and jurisdictions and includes people who have backgrounds in structuring, origination, ratings agencies, monolines as well as in asset management. This allows us to evaluate relative value across an extremely diverse global ABS opportunity set. We assess sector relative value in a collegial, flexible and dynamic fashion. Strategic asset allocation decisions are typically discussed at our weekly team meetings. However, tactical trading happens in real time. 

EH: CQS delivered its best annual return of 72.81% during 2008, a year when most hedge funds invested in credit derivatives suffered huge losses brought on by the collapse of the sub-prime mortgage market. How was it that you were able to achieve this remarkable feat?

We had a strong view that the rapid deterioration in the value of assets underlying ABS was not fully understood or priced into the market so the fund ran a net short position in 2008. We shorted RMBS by buying protection on subprime tranches, CDOs of RMBS and the ABS index. Additionally, we looked for institutions whose equity or credit securities we believed were misvalued based on their exposure to ABS, which we shorted via CDS and/or equities. We do not expect this kind of dislocation to recur any time soon, but we continue to see good opportunities to generate positive risk-adjusted returns for our investors on both longs and shorts.

EH: Further to the above, how has the credit market evolved since the global financial crisis of 2008? What would you say are the main differences between your portfolio of ABS and CDS instruments then and now?

Many aspects of the markets have changed since 2008 when the fund was in its early days. There is less leverage in the system generally; there has been more government intervention and asset support; there are fewer instruments to short ABS directly; and there has been a return to an alignment of positive fundamental and technical forces in many ABS sectors.

EH: Can you share with our readers a rough breakdown of your asset allocation by geographic mandate? How has your allocation changed over the years and what were some of the key trends guiding this change?

The team is located in London and New York giving us excellent insight into the two largest ABS markets. The portfolio has consistently had exposure to both US and Europe. Over the past year, we have expanded our European exposure to roughly 30% as our view of Europe becomes more constructive, with both fundamentals and technicals becoming more positive. The European portfolio is focused primarily in the UK and Germany. We have also been looking at peripheral Europe with great interest and we have done considerable due diligence there. We anticipate increasing our investment there opportunistically. In every case, though, we perform asset level analysis and have a thorough understanding of the capital structure.

EH: As the role of government sponsored entities such as Fannie Mae and Freddie Mac is being reduced, do you see private capital investors such as your fund playing a greater role in the future? How would that feature into your fund’s strategy?

This is a great question and we think it is a good opportunity for us. In the near term, the Government Sponsored Entities (GSEs) are responding to their regulator, the FHFA, by de-risking in two ways. Firstly, selling off their ‘retained’ portfolio of non-agency MBS. This stands at US$128 billion as of February 2014 down from US$185 billion a year earlier. Secondly, the ‘credit risk transfer’ deals (FHLMC STACR and FNMA CAS) allow investors to participate in the performance of the GSEs’ prime conforming portfolios. We selectively participated in both of these opportunities. In the longer term, multiple GSE reform proposals are working their way through Congress. All of these call for private capital to flow into US housing finance to supplement and/or replace government programs. With our expertise in mortgage credit, it is likely we will see some interesting opportunities.

EH: Institutional investors are increasingly allocating to larger hedge funds with solid track records rather than smaller start-ups. How has this trend affected the ease in raising additional funds for billion dollar hedge funds such as yours? Could you share with us how your investor profile has changed over the years as your fund size has grown?

I think that is right. At CQS we have close to US$13 billion of assets under management; that enables us to invest in the platform more broadly and specifically in a robust operations and risk infrastructure. The ABS Fund also has a seven year track record. The combination of these factors is certainly supportive to attracting new investors. Ultimately, however, we need to demonstrate we can continue to produce attractive risk-adjusted returns for investors. We take a careful approach to capacity management and we have in the past closed the fund to new investors. 

Over the past two years the most significant shift in the fund’s investor base has been the increase in the proportion of institutional investors (pension, insurance and sovereign wealth funds) and a corresponding decrease in funds of hedge funds.

EH: The CQS ABS Fund has not experienced a single down year since its inception in 2006. What are your main principles in limiting your downside volatility?

Investors value the Fund for its low volatility return stream and its limited correlation to other funds and sectors. Diversification and low beta sectors in the long book and our approach to hedging have contributed to this.

EH: With the Fed remaining committed to its QE wind-down, how will a reduced demand for RMBS impact the market in your opinions? Furthermore, assuming interest rates start to move northwards in a year’s time, what opportunities and challenges would that create in the space of ABS.

The Fed's QE program has utilised treasuries and agency RMBS, while the Fund's RMBS investments are primarily non agency. A likely effect of the wind down of QE will be higher rates. However, the overwhelming majority of ABS securities are floating rate and higher rates should have a minimal effect. We also anticipate a continued shift from fixed to floating rate assets. From a portfolio standpoint, the withdrawal of QE should result in a widening of credit spreads generally and we have in place hedges that will benefit from higher rates. We also have a tactical short position in agency MBS which should benefit from the reduction in Fed MBS purchases.

EH: The Dodd-Frank act and new Basel III requirements, have forced banks to reduce their holdings of credit derivatives to deleverage their balance sheets, with less regulated entities like hedge funds taking up their space in the ABS market. How has that benefitted your fund? How long could this trend of balance sheet deleveraging be expected to last?

We do expect bank balance sheets to continue to shrink over time. The types of assets held by banks will be materially impacted by Basel III, but we are not proponents of the view that there will be a cathartic moment when banks, predominantly European banks, will jettison assets at low prices. Consequently, we believe good investment returns will be driven by hard work and a focus on fundamental analysis and judgement.

EH: As the S&P Case-Shiller 20-City Home Price Index continues to break new highs, do you expect a slowdown in the recovery of US home prices any time soon? How would this scenario affect your US RMBS portfolio?

The CS Index was up 13% in 2013. Analysts’ estimates for 2014 are for a further rise of between 3% and 6% and we believe the market continues to price in quite conservative assumptions for default and recovery rates.. One of the major drivers to performance in 2014 will be as improving performance is realised and is increasingly priced into the securities.

EH: On a final note, what are some of your high conviction themes for the near future with regards to the asset backed securities market?

The main bigger picture attractions of ABS are that it is mainly a floating rate asset class, supported by improving fundamentals and positive technicals. In terms of more granular investment opportunities, in Europe, specific pools of Spanish RMBS look attractive and have particular potential for tightening relative to sovereign and covered bonds. In the US, servicer behaviours and loan repurchase claims continue to be among the major drivers of US RMBS cash flows. Here we are currently favouring subprime mezzanine tranches. Lastly, we see good opportunity in monoline insured cash flows with event driven returns related to insurer rehabilitation; wrapped municipals as well as wrapped ABS.


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