Bryce Doty leads the Sit Taxable Fixed Income team and is a portfolio manager along with others on the team.

Q1. Please describe your investment philosophy, the background why you have decided to focus on seasoned MBS, and how you invest.

Our philosophy is to seek and provide consistently superior risk-adjusted returns. Experience shows us that the use of high coupon, seasoned agency mortgage-backed securities, which place an emphasis on interest income and stability of principal value, accomplishes our goal.

This strategy originated in the 1980’s when Sit observed that some mortgage securities had very high coupons compared to prevailing mortgage rates. Sit investigated the reasons why an individual homeowner would not refinance their mortgage at a lower rate when the opportunity was available. After significant study, it was determined that several characteristics of borrowers and their loans often caused homeowners to continue making monthly mortgage payments rather than refinancing.

Furthermore, Sit discovered and embraced the lower price volatility of these securities. High levels of income and less portfolio price movement result in superior risk-adjusted returns. The strategy was further enhanced by portfolio managers Bryce Doty and Mark Book. They discovered additional opportunities in seasoned mortgages as the housing market expanded and became more complex. The key to this strategy is a high coupon income and low, stable level of prepayments.

 

Q2. Please let us know where you find investment opportunities today.

Sit builds portfolios from the bottom-up, purchasing securities with characteristics that provide stable prepayment levels, high income and small price movements. This investment strategy consists primarily of high coupon, seasoned, agency mortgage securities in all interest rate environments. We are able to purchase these securities through a dealer network of 8-10 firms that specialize in this specific sector of the mortgage market. Sit often receive the first opportunity to buy these mortgages because of our constant demand for them. Our consistent use of these securities is a key to us being able to construct a portfolio in a timely manner with favorable yield and duration characteristics.

In the current low interest rate environment, we further reduce portfolio volatility by hedging the already low interest rate risk. Importantly, it is our intent to maintain a minimum portfolio weighting of 75% of high coupon, seasoned agency mortgages throughout an interest rate cycle.

 

Q3. Please explain why you have decided to be a portfolio manager.

I decided to become a portfolio manager once I realized the many benefits that investing provides to a broad group of organizations and people.

Clients occasionally ask us to discuss what we are most proud of during our portfolio and market review meetings. We respond that we are proud of our portfolio returns because of what our returns represent. We manage individual’s money in our mutual funds. The more money we earn for them, the more goods and services they can afford. We manage money for charitable trusts and endowments. The more money we earn for them, the more services they are able to provide to the less fortunate. We also manage pension assets. These earnings improve people’s retirement. In the case of insurance companies, the more money we earn for them the more able they are to serve their clients in their clients’ time of need.

The reason I am a portfolio manager and what I am most proud of is the ability I have to improve people’s standard of living.

 

Q4. What is your belief as a portfolio manager? What do you try to achieve and what you would never do?

I believe that in order for portfolio managers to be successful they need more than experience and education. I tell my staff to remember three words to help us achieve our clients’ investment goals:

-Conviction
-Action
-Discipline

It is important to have conviction about the economy, interest rates, inflation, fiscal policy, and monetary policy. Knowing specific details regarding such issues as the structure of a bond, a company’s financials, or delinquency trends for a specific pool of loans and having a strong expectation for the range of future trends for these issues is also critical.

Once an analyst or portfolio manager has a conviction about future trends and which securities will do well in that environment, they need to take action if the current securities in the portfolio are materially different from what would be purchased for the portfolio if it were all cash. This helps portfolio managers resist becoming too comfortable with a sub-optimal portfolio when investment conditions change.

Discipline, in this instance, refers to understanding what conditions would need to exist for the sale of each security in the portfolio. There could be a certain time frame, a particular level of interest rates, a level of a corporation’s profitability or rating, a change in the shape of the yield curve, or a combination of factors that mark when the security has achieved its desired purpose in the portfolio. Knowing this at the time of purchase of a security helps instill a sell discipline by envisioning various desired exit strategies.

Lastly, it is important to think at least one step further ahead than normal. I remind our group that the average chess player thinks three moves ahead will generally beat a more intelligent expert player that chooses to only think two moves ahead.

Regarding what I would never do, I do not invest in securities that I do not fully understand. Furthermore, I believe it is a bad idea to invest in anything that I would not be able to explain to my clients. I also avoid securities that I consider too risky for clients, even though they may be allowed by the guidelines, when I believe the risk level to be incompatible with the clients’ investment goals. I believe that the trades that I decide not to do are far more important than the ones I complete.

 

Q5. How best would you protect clients’ assets?

It is important to understand each client’s investment goals when determining how to best protect their assets. While benchmarks are useful measuring sticks, they are less useful than knowing the portfolio restrictions as well as the spirit and intent of the guidelines.

We believe that bottom-up detailed analysis of each security is very important for protecting client assets since the details are most critical when problems arise. Examples include covenants in corporate bonds and precise waterfall rules for cash flows in a structured multi-tranche security.

It is important for us to use securities with a history; those that have been through an interest rate cycle. We tend to avoid new Wall Street creations. We also avoid baskets of securities such as CDO’s because we like to buy the best bonds in the basket directly without having exposure to the lesser quality bonds.

We seek securities with stable and predictable cash flows with prices that are generally more stable than similar duration U.S. Treasury bonds. While this means that we may not have as much price appreciation when interest rates are declining, we provide our clients relatively more protection when interest rates are rising. Some clients also allow us to further protect the value of their assets by allowing us to hedge their portfolio duration. We generally accomplish duration hedging by shorting U.S. Treasury futures contracts.

 

Q6. Please recommend your favorite books on investments, and the reasons you favor them.

I like Michael E. Porter’s “Competitive Advantage of Nations” as I like to apply the macro concepts in the book to microeconomic issues, regional corporate competitors, and even psychological and cultural issues that effects politics and investor behavior.

I like Ayn Rand’s “Atlas Shrugged” for how it demonstrates the importance of the free flow of capital and resources.

I enjoy articles and studies on the topic of behavioral finance as I believe that human emotion quantifies how risk/reward is priced in the marketplace. Understanding this also helps reconcile the flaws of pure efficient market theory. I sometimes joke that my minor degree in psychology has been more useful than all my finance classes.

We also encourage every new analyst to read Michael Lewis’ “Liar’s Poker” to understand how Wall Street’s short-term incentives are misaligned with our clients’ long-term investment goals.

 

Q7. Please recommend any media source (newspaper, journals and website) you check on a regular basis.

I read the Wall Street Journal most days and review the top news stories of the day on Bloomberg that relate to recent economic data. I avoid most other publications in order to develop independent conclusions and strategies. I prefer to directly access the source of economic data rather than form my opinion based on others analysis of the data. I primarily read the news stories to get a sense of what the prevailing sentiment is to better predict how the market might react to what it would consider surprising news. Many of the best opportunities are created when a trend is ending and a new one forming as it produces a divergence of opinions. Here are some of the sources for data that I use most frequently:

-Fannie Mae: www.fanniemae.com
-Freddie Mac: www.freddiemac.com
-US Census: www.census.gov
-US Bureau of Labor Statistics: www.bls.gov
-National Association of Realtors: www.realtor.org
-Mortgage Bankers Association: www.mbaa.org

Nearly all data has flaws and is more useful and accurate during certain periods of the economic cycle than other periods. It is important to understand and take advantage of these flaws.

Sit Investment Associates, Inc. (Sit) was founded in July 1981 and became registered with the SEC on September 18, 1981. Investment management is the sole business of Sit and 100% of the firm’s revenues are derived from investment management. As of June 30, 2021, Sit managed $16.6 billion in total assets; $14.0 billion in Fixed Income.

Sit is an independent, employee-owned investment management firm with clients across the globe; the firm is based in Minneapolis, Minnesota - USA. Sit qualifies as a minority-owned (Asian-American) firm.

Sit offers a range of investment strategies and custom strategies to meet client needs. Sit has investment expertise in the following areas:

-Taxable Fixed Income: Investment-grade and Alternative investments
-Municipal Bonds: Investment-grade and Alternative investments
-US Equity: Growth and Dividend Growth
-International Equity: Developing markets

Seasoned MBS strategy
The objective is to outperform the Merrill Lynch 3-month Libor Index over an interest rate cycle with less return volatility.
The strategy utilizes seasoned, high-coupon, low duration U.S. Agency pass-through and CMO securities similar to the short duration strategy referenced below. There are two differences:

-Up to 3.5 times leverage is applied ($1.00 becomes $3.50) using repurchase agreements.
-Duration is hedged to a range of -1.0 to +1.0 year by shorting 2-year Treasury futures.

Short duration strategy
The objective is to outperform the Barclays 1-3 Year Government Index over an interest rate cycle with less return volatility.

-Relative incremental value is achieved primarily through emphasis on seasoned Agency mortgage pass-through securities. Gradual shifts in portfolio duration within a range of 0 to 3 years are made in concert with Sit’s economic outlook and interest rate forecast.

-Fund managers search for securities providing high current income relative to yields currently available in the market. Considerations include prepayment risk, yield, maturity, and liquidity.

-A majority of the holdings in the short duration product consist of seasoned, high coupon U.S. Government -Agency mortgage pass-through and CMO securities. These securities produce high levels of income due to their much higher-than-market coupons and relatively stable prepayments.

-The underlying loans have been outstanding for many years and the homeowners have had a long-time frame and many opportunities to refinance at lower interest rates. The vast majority of the borrowers in the original loan pools we purchased have already paid or refinanced their loans. The low average loan balances in the securities we buy allows homeowners to achieve only a small savings in monthly mortgage payments; often less than $50 per month. The fees associated with a refinancing for these mortgages generally makes it uneconomical.

Risk Management
Risk management is important in achieving strong risk/adjusted returns. Sit monitors portfolio interest rate risk by measuring traditional durations based on expected average lives and effective durations based on the actual historical price movements of individual securities. Other risk factors include:

-Interest Rate Risk: Duration is kept within 20% of the benchmark. Sit has the ability to hedge duration using U.S. Treasury Futures.

-Credit Risk: Minimal. Most securities are U.S. Treasury/Agency issues rated AAA.

-Prepayment Risk: The mortgages in this strategy are seasoned, high coupon securities which have relatively stable and predictable prepayment characteristics. They also have relatively short durations and therefore do not have the price risk of more traditional MBS issues.

-Yield Curve Risk: Outperformance comes from strong risk-adjusted return with an emphasis on income, not on the direction of interest rates.

The information provided herein has not been reviewed by any regulatory authority. It is not intended as an offer, solicitation, advice or recommendation to buy or sell any securities or any products. To the extent permitted by applicable law, none of　Sit, its affiliates, or any officer or employee of Sit, accepts any liability whatsoever for any direct or consequential loss arising from any use of the information, including for negligence.