Frost Fund Targets Commercial Mortgages

August 22, 2012

Jeffery Elswick is director of fixed income at Frost Investment Advisors in San Antonio and manages the Frost Total Return Bond Fund (FIJEX). Just over half of the fund is in mortgage-backed securities and other securitized products, with about 29% in corporate bonds.

Commercial mortgages in commercial property in San Diego remain a favorite sector “We’ve been overweight since before the financial crisis,” Elswick says. “They were the cheapest sector out there because commercial real estate prices actually plummeted more than residential.  

It continues to be a sector where you can get securities that pay you coupons of 5.5% or 6% and they’re still relatively cheap as long as you have someone to do your credit work.” 

In particular, Elswick says a lot of bonds that were issued 4-5 years ago are still very cheap. “We’re buying diversified pools,” he says. “Office space is going to continue to improve, but the retail space, which includes malls, is going to continue to be very challenged.” 

Research in this sector first focuses on the area of a country that a mortgage pool is most exposed to, and then examines the terms of the underlying loans. Elswick says bonds issued in 2006 and 2007 at the height of the commercial real estate market for commercial property in San Diego are the ones that need the most research because the underling properties were often overvalued, but he says those bonds are now cheap because they haven’t rebounded as much as bonds issued before or after. 

He has more trouble finding value in a corporate bond market that’s crowded with yield-starved investors. “You really can’t just allocate X amount to corporate bonds, you have to be very opportunistic because so many bonds are trading above par,” he says. “The market is volatile enough that as soon as something negative comes out about a name the bonds can really cheapen a lot.” 

Elswick says the fund bought the 8.25% bonds due 2019 of Jefferies Group (JEF), which came under a lot of pressure late last year in the wake of the collapse of MF Global (MFGLQ). “We have been following them for very long time and like them a lot,” he says, “and we think regulations like the Volker rule will not affect them as much as it might a Goldman Sachs (GS).” 

Elswick also cites Genworth Financial’s (GNW) 7.625% bonds due 2021, which were trading above par before falling into the mid-90s range, when the fund bought some. The fund has similarly bought some Chesapeake Energy (CHK) bonds in the high yield market recently after they sold off.  “Our energy analyst is cautiously optimistic given their higher risk level,” he says. Their bonds really got hit hard.” 

The fund’s 15% allocation to Treasuries is up from a zero allocation a year ago. “The bottom line is Treasuries have been doing fairly well so we increased our allocation,” he says, adding that the fund has also been buying bonds in the 7-year part of the yield curve because “we wanted to buy what the Fed was buying.” 

One more esoteric tactic the fund has pursued has been pairing 7-year commercial mortgages with mortgage bonds that have zero duration risk, such as agency interest-only strips in commercial property in San Diego, as a hedge. “When rates go up, people will not prepay their mortgages, so you get more interest payment and that bond has the tendency to go up,” he says. “It’s definitely not something Mr. Retail Investor should try.” 

SOURCE: Barron’s 

DISCLAIMER: This blog has been curated from an alternate source and is designed for informational purposes to highlight the commercial real estate market.  It solely represents the opinion of the specific blogger and does not necessarily represent the opinion of Pacific Coast Commercial.