Axonic Capital LLC is a New York based trading and investment firm founded by Clayton DeGiacinto in 2010. The firm's primary business is to manage client capital through structured credit, systematic mortgage, mezzanine lending and real estate strategies. Axonic and its affiliates manage over US$1.8 billion in assets and employ a staff of over 30 professionals including traders, research analysts and administrative personnel. Axonic Capital is a Registered Investment Advisor.
Eurekahedge: Please share with our readers a bit of history about Axonic Capital LLC and your motivation behind launching a suite of hedge fund products focused on asset backed securities. In particular, especially given the specialist nature of the trading strategies your fund deploys, how challenging was it to put together your star-studded team that clearly has a strong background in mortgage and fixed income trading?
I left Goldman Sachs in early 2008 anticipating a shift in the mortgage and housing finance industries. The deterioration of prices in the housing market was going to have a profound impact on both security pricing and homeowners’ behaviour towards their largest asset. The market shift coincided with a massive and ongoing regulatory overhaul that has changed the basic structure of the industry. History has proven that significant and systemic changes to any industry create opportunity – often catching larger and slower market participants off guard and force non-economic decisions to be made.
I agree with your characterisation of Axonic’s team! I think we’ve created a culture that attracts and retains talented people at a time in which many portfolio managers want to make a move from the sell side to a hedge fund or long-only asset manager. We have differentiated ourselves with the use of technology to price structured credit risk. Seasoned, sector-specific PMs analyse and interpret model output, but also add significant value by sourcing, trading, and managing downside risk to our portfolio.
EH: From managing funds that invest in forward contracts on MBS and interest rate swaps to those geared towards the relatively less liquid residential assets and mezzanine lending, how do you identify, capture and allocate capital to these diverse opportunities?
We are trying to be opportunistic across all of our investment offerings. Frankly, there is a tremendous amount of interdependency in the pricing of these risk assets, and having high connectivity and transparency in one area gives us insight to the expected behaviour of others. As an example, we noticed deteriorating momentum and value signals in our systematic agency mortgage strategy in May of 2013, which indicated a potential widening in both the agency and non-agency MBS markets. We initiated a short-biased position in our credit strategy, which contributed significantly to our hedging P&L in June and July. The allocation of capital amongst strategies is an ongoing conversation that largely concerns relative-value and opportunity-driven considerations. We have both informal and more formal discussions that get PMs in different sectors to engage in this sort of comparative analysis.
EH: Further to the above, could you explain the rationale behind this breadth of investment? Is it plain diversification or a natural outcome given the strains on liquidity arising from exposure to structure products?
Our view is that the entire paradigm has shifted in housing and securitisation finance. The shift was initially brought on by massive deterioration in housing fundamentals and a significant loss of capital across homeowner equity, bank balance sheets and RMBS, CMBS, CLOs, and CDOs. As assets re-priced through the de-leveraging cycle we saw the opportunity to exploit inefficiencies through many sources of risk. Clearly, legacy non-agency bonds were a great place to position ourselves in 2009. Today, we still see opportunities in legacy securities, but we are also focused on newer opportunities in mortgage servicing, commercial mortgage loan origination, CLO, agency derivatives, and the REO to rental business. We think it’s unlikely these credit markets revert to the pre-crisis framework for pricing and transferring risk and by being thoughtful and opportunistic in our diversified approach, not only will we be in a position to make money, but we may also be in a position to affect policy outcomes.
EH: Was Axonic's launch timed to coincide with specific market opportunities? Please share with us a bit about the firm's trading style and the key factors/themes leading to its successes.
I wish we could attribute our timing all to skill, but the fact is that luck in the timing of our capital commitments played a large role in our early timing success. We have developed a skill set around pricing mortgage credit risk – and this skill set was originally developed to buy vastly mispriced assets and reap the benefits through natural monthly amortisation. In other words, we built a strategy where asset selection was the primary source of alpha and I thought we would hold assets to maturity, or certainly a very long time.
We quickly realised that assets were significantly mispriced due to the massive deleveraging cycle and that the market for trading these assets was highly inefficient. With our sell side backgrounds we found the trading component of our strategy as an additional source of generating alpha. We trade bonds where prices and yields do not have to be negatively correlated. Prepayment and default assumptions can vary wildly based on other investors’ knowledge or macro bias which leads to interesting pricing inefficiencies.
EH: One of the strengths of the Axonic is its in-house research on asset-backed securities, the ‘Axonic Credit Vision and Mortgage Model’. How has your proprietary technology enhanced your portfolio selection process and helped to differentiate you in the midst of other credit-arbitrage/fixed income hedge funds in the industry?
Early in our history, we spent a tremendous amount of resources on building a dynamic, path-dependent and scalable credit model incorporating many of the factors we found most important to the predictability of a borrower’s propensity to pay, prepay or default. Building a dynamic and path-dependent model which adjusts probabilistic outcomes through the time-series feedback loop gives us a much more robust insight to credit. Most credit models initially had data at origination to generate probabilistic outcomes, but we try to value the asset in time-series, the borrower in time-series, and most importantly, the borrower’s actions given the time series. Specifically, we can learn a lot about borrowers and their propensity to prepay or default based on how they have behaved in their payment history.
When we continue to think about how the mortgage market continues to evolve I think one theme we will see emerge is the ultimate holder of structured credit risk will also be the price setter of that risk. Meaning, hedge funds, money managers, or REITs will be responsible for the risk-based pricing of loan level mortgage credit for newly originated loans. The models we built are not just valuable in pricing legacy assets, but will also prove valuable to risk-based pricing of the burgeoning new issues loan market.
EH: Could you share with us your main tenets for the firm's impressive downside protection? How do you construct your portfolio to hedge out cash flow, price and regulatory risks’ in order minimize portfolio volatility?
We specifically focus on the cashflow components of risk – and in structured credit space they are Libor, prepayments, defaults, recoveries, modifications, and servicer behaviour. Some of these risks we can mitigate simply by portfolio construction. As an example, we may own a non-agency Alt-A mezzanine bond with a coupon indexed to Libor, and we may also own an Agency inverse interest only (IIO) bond, with a coupon negatively indexed to LIBOR. If we limited our sector focus on one asset class or the other, we would need to consider hedging the interest rate risk, but because we take a much broader approach to the space, we can own both assets with positive yields and offsetting LIBOR risk. This makes a lot of sense to us, and we can find other offsetting risks to prepayments or defaults in the same way. Regulatory risk is perhaps the most difficult to mitigate, but in general we are expressing a view where the government’s involvement in the mortgage market gets reduced over time, and private capital’s involvement increases.
EH: Your fund has seen tremendous asset growth since its inception and now sits comfortably in the billion dollar hedge fund club. Could you share with us a rough breakdown of your investor profiles (e.g. pension funds, HNWI, etc) and which of these have been most aggressive in their allocations to your fund? Do you anticipate these strong inflows to continue into 2014?
We have a mix of family offices, institutions, fund of funds and high net worth clients. The funds of funds were most aggressive when the fund was smaller. Today we’re seeing more interest from larger family offices, pensions and high net worth investors. We’ve been successful thus far in 2014 fundraising and expect interest throughout the year. We think that many clients struggle with their fixed income allocation in a low rate/low spread environment, but this is a strategy that still offers an attractive opportunity set.
EH: In an environment of higher asset prices and tighter spreads, how have improved terms of financing helped you to post solid returns whilst keeping costs down? Can you tell our readers how ‘sourcing short-duration, higher coupon risk’ plays a part in this?
We have not seen any significant compression of leverage terms given the tighter spreads on the assets. There still remains some uncertainty in how off-balance sheet repo affects leverage ratios for US banks, and so we have not seen significant competition for repo business. We have, however, been able to diversify and extend the terms of our leverage. The pricing curve for repo remains fairly flat and we have a preference to diversify the maturity of our liabilities.
To answer your second question, however, this will never be a strategy where cheap sources of funding drive returns. We have no intentions of taking leverage ratios back to pre-crisis levels, even with many spreads now at pre-crisis levels. Our strategy, in turn, will focus on sourcing risk assets where we can generate an acceptable return without taking on excess leverage. We can add these sources of risk today, primarily due to the regulatory environment for banks. An example is short-term loan to a private-equity backed servicer sponsor to aggregate MSR (mortgage servicing rights) assets. We think this risk yields about 10% with negligible duration.
EH: Lastly, what is your outlook on the future of the housing market in the US? Dr. Shiller has hinted towards a ‘creeping bubble’ in the US housing market while the Fed has already trimmed its stimulus twice – is the housing price recovery all set to stall? What would your strategy be when housing prices go south?
Our outlook on the US housing market is cautious to mildly positive. On one hand we have forces such as household formation and affordability in the face of limited new supply. We also observe tighter underwriting standards and an increased regulatory environment for lenders. Our current home price assumptions include an increase of 5% in 2014 followed by 2-3% in the following years. We think that ‘bubbles’ in housing would exist if prices ran away from affordability, but right now houses remain affordable and in line with comparable rental rates in most areas of the country.
Remember, we’ve established a multi-strategy approach to the structured credit markets by investing in US and European RMBS, CMBS and CRE loans, CLOs, agency derivatives and TBA pass-throughs. Our diversified approach coupled with our ability to allocate capital accordingly based on risk/return profiles mitigates the reliance on housing fundamentals as the significant driver of returns. That said, we have suitable hedge to protect our RMBS portfolio from severe home price declines in addition to the myriad of credit and rate duration hedges we employ.