In 2006 Charles Melchreit was looking for a job. His search took him to the Federal National Mortgage Association. He was all set to join the firm, better known as Fannie Mae, but something didn’t feel right.
Assessing his options, he called up a recruiter who told him about an opening at Pioneer Investments. Fast forward and Melchreit is now the firm’s director of investment grade management and oversees the £3 billion (€3.5 billion) Pioneer SICAV – Strategic Income fund with Kenneth Taubes and Andrew Feltus.
Melchreit’s hunch about Fannie Mae clearly proved a good one. It wasn’t long before this company, along with Freddie Mac, the other government-backed US mortgage giant, found itself at the centre of the global credit crisis.
But the close shave hasn’t put the Citywire A-rated manager off the mortgage market, quite the contrary. As a value investor, he has taken a contrarian stance and has gradually increased his allocation here as valuations have fallen. He believes the US Federal Reserve will continue to support the market and will take a measured approach to any tapering on interest rates.
‘They have a particular focus on extending the recovery in the housing market and therefore the building trades in the US.
‘The purpose of QE and buying mortgages was to push down mortgage rates, make houses more affordable, support new building construction and underpin employment within the building trade. It would be illogical for them to do a 180 degree turn at this point,’ he says.
‘They have also been very clear that policy adjustments, on the rates side, will be very gradual. The market has overreacted to the potential for a taper and we see that as an attractive area and valuations are attractive too.’
Melchreit has 34.9% of the fund allocated to residential mortgage-backed securities, compared with a benchmark weighting of 23.7%.
Agency mortgage-backed securities make up 24.4% and he allocates 10.5% to non-agency residential mortgage-backed securities.
His judgement is working. The fund has returned 41.7% in the past three years and ranks second in Citywire’s Global Bonds sector out of 887 peers. This has beaten the third-placed contender by about 20% over an admittedly tough time frame.
Phoning it in
While he might not be worried about the mortgage market, one area of the commercial fixed income sector that does concern Melchreit is US telecoms. He says valuations here are becoming unattractive, spreads are tightening and business models are under strain.
‘AT&T and Verizon have been significant issuers of debt, they have very high capital investment requirements that force them to continue to come to market as they replace their existing infrastructure. Their growth prospects are beginning to fade and we are starting to see more price competition,’ Melchreit says.
‘Even though the mobile phone business is an oligopoly there is a price war brewing. The revenue stream is weakening, technology continues to evolve rapidly and yet they are coming to market with a 30-year debt. We don’t know what Verizon or AT&T or T-Mobile are going to look like in 30 years, the investment thesis is very difficult and we have reduced our allocation.’
As telecoms companies issue more debt, they increase their weighting in the index but Melchreit warns against blindly following benchmarks. His 31 years’ experience in the industry means that he has seen a similar situation turn sour before.
‘This reminds me of what happened in the late 90s with the tech bubble when we had issuers like Global Crossing who were dominating the high yield market. They were issuing a lot of bonds and all the high yield managers had to have them. If you were following the market weight, you were forced to buy what was essentially an over-leveraged issuer. That ended very badly for a lot of investors,’ he says.
This is an extract from a longer article which orginally appeared in the May 2017 edition of Citywire Selector.