Nancy Zimmerman – People, Process, and Fixed Income Arbitrage at Bracebridge (EP.517)

0:00You learn a few things during crises. You want to have liquidity, flexibility to be able to lean into dislocations, especially things where you know them well. You feel like you are positioned to take advantage of it, maybe make it go away. Every crisis teaches and reinforces that you want to stress test. You want to think carefully about what factors could cause a drawdown in your portfolio. You want to think hard about what's the difference between a drawdown and a capital impairment because those are different things. Also thinking about what doesn't work. What are you relying on in terms of institutions, courts, banks, counterparties, these kinds of things.

0:43You learn them in your first crisis and you never forget them. Stuff begins to rhyme for you. The most important thing that we learn is good people who are curious, have thought through things and can maintain their curiosity, their bearings and have a real sense of rigor and purpose are vital to those moments.

1:13I'm Ted Seides and this is Capital Allocators. My guest on today's show is Nancy Zimmerman, the co-founder and managing partner of Bracebridge Capital, a$13 billion alternative asset manager specializing in fixed income arbitrage that she founded over 30 years ago in 1994 alongside Gabe Sunshine with Capital from David Swenson at Yale. Our conversation traces Nancy's evolution from pricing securities to investing and the enduring sources of inefficiency in fixed income markets. We discuss the nature of arbitrage opportunities and their persistence over time, and then turn to hunting for mispricings today across developed market rates, structured credit, corporates, and emerging markets.

2:02Along the way, we cover Bracebridge's process for sourcing ideas, assessing relative value, determining position sizes, constructing a portfolio, and managing risk. We close with building a team, aligning the organization and its clients, investing in today's exciting and unusual environment, and transferring investment knowledge to work on the Investment Committee and Brain Science Research at Nancy's alma mater, Brown University. Nancy is among the sharpest, most curious, funny, and deeply experienced investors in the hedge fund world. Before we get to the interview, we spend a lot of time on this podcast asking other people questions.

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5:42We use Alex and our team at Capital Allocators swears by it. Try Alex for yourself at the link in our show notes, tryalex.admiredleadership.com. And I hope you enjoy my conversation with Nancy Zimmerman. Nancy, it's so fun to do this with you. Glad to be here, Ted. Why don't you take me all the way back to the influences growing up that had some impact on what's happened today? I grew up outside Chicago in Skokie, Illinois, and I went to Brown. I was a sophomore at Brown where I was doing some math and some computer science, making some large metal sculptures for Christmas. I got a job at a art gallery.

6:30Sometime before I got home to take that job, it went out of business. I came from family where you had a job. I needed to get a summer job. My sister, who honestly is perpetually out of my back my whole life, introduced me to some guys who had about five years earlier, Dropped out of MIT to start an options arbitrage firm at the Chicago Board of Options Exchange at the SIBO, backed by some grain traders. O 'Connor and Associates, they gave me a summer job running messages, doing things super eye-opening. I found out about options markets. It was a combination of news and math puzzles. I was lucky with my timing.

7:11It's 1983. So it's just learning how you use a personal computer. if you put somebody on the floor of an exchange with a shark. It has quotes. You can figure out how to manipulate them in a tiny little program so that you can arbitrage the difference between that Kansas City value line and the S &P 100. The way that they used to do this before this moment is they would make a piece of paper. They would write down every price they could imagine for one of them and then where they wanted to do the arbitrage on the other. This was replaced by five lines of code. They had a huge pedagogical interest in educating everyone because they sat in crowds where people were always giving away money.

7:53They went through a lot of trouble to make sure that everybody who worked there understood how to price things, put call parity, where the arbitrage free forward was. They were careful to go through in a very detailed way what we know and is like physics. What is an assumption so we can make the Black Shoals work? They would do these things that were time intense. You would have somebody who was the partner in charge of risk arbitrage go through how to do a binomial tree. to figure out how the math worked. A very big focus on the distribution of returns of a trade, what it meant to make prices, how one price related to another, thinking about when we use models to describe prices, volatility, what goes into that, what were our assumptions.

8:48They spent a lot of times making sure that you understood how to price a box, call and a put of one strike versus a call and a put of another. They did a little bit gloss over of why markets move. They were uninterested in macro or any things that weren't bottoms up around pricing options or pricing other derivatives that it drew your attention to this part of the program. I spent a lot of time at Brown after that doing coursework. halfway through Brown, you can decide, I want to know everything there is to know about statistics and probability. It is interesting to see how small things that are serendipitous feed into what happens.

9:35Then I went back to O 'Connor after I said, if you can get back here on June 5th and take this test, you can go to the floor and make prices in Swiss franc options, which is the third market for Swiss franc options, which means there's six people sitting at the Merck who are looking at boards to see if they can arbitrage or make prices that are wide enough to capture some more bid offer and lay the risk off in the other two markets. It was a great experience. I learned to make prices. I was on the floor during the middle of Plaza Accord when they decided, we're just going to put the dollar in a different place.

10:12Those things stick with you to see big currency interventions to understand how all the pieces work together, how currencies and bonds work together. I was a market maker in currency option, probably all the majors. O 'Connor did a tie up with some guys for Chicago, which was a big deal internally. At some point, they started a bond initiative. The bond options at the Board of Trade was a huge crowd. The futures were active. It was a lucrative business for them, and they decided they should be more involved in the over-the-counter business. They hired some people. I went over that. I don't really remember why.

10:52I found out about bonds. I found out there's all these cash flows. At that time, there were only three instruments describing U.S. risk-free interest rates. Now there's 48 in the first three years of the curve. I went and I found out about bonds, basis trade, cheapest to deliver plays, cash for future arbitrage, doing market making. How did you get from that initial seat to eventually starting Bracebridge? There was a crash in 87. This one, stocks used to go down.

11:27And O 'Connor was an equity place, a little bit of a retrenchment into that. And I went to Goldman to try to see if I couldn't help them build a platform that made prices in U.S. treasury options everywhere. It was exciting. I learned a lot of things. I spent a third of my time making prices or managing somebody who made prices, a third of my time doing the kind of things you do to have a vibrant, fabulous business like Goldman has, building models, cultivating clients, working with clients, educating salespeople. And I spent a third of my time, proprietary trading, trying to take advantage of the difference between two completely fungible cash flows in the U.S.

12:10Treasury curve or two options that were on the same part of the yield curve, stripping and reconstituting bonds. That third was what lit me up. I was always interested in figuring out why is this happening? How much worse is it going to get? What's going on here? What are the flows that make this happen? What are the institutional arrangements that make it happen? I wanted to have my whole day be like that last third of the day. I went out into the world to try to find a way to do that. Eventually, a lot of wanderings leave me in an office, sitting with David Swenson and Dean Takahashi. David was the grandfather of the SWAT, talking about how he built that and LIBOR and why aren't these things efficient.

12:54I tell David what I do. There's a lot of alpha in fixed income. There's too many instruments describing the exact same things. You can generate an uncorrelated return by putting them together and make a diversifying set of cash flows. He loves the idea. And I said, isn't somebody else doing this? He said, no. Every time I meet somebody who says they're doing this, they spend a lot of their risk capital and time, guessing which way rates are going. We immediately click because we both have this bedrock idea that this is not a good sport to play at the same time as trying to do what we then called fixed income arbitrage.

13:37It was the start of a beautiful partnership. I had this unbelievable privilege of building a tool that I hope helped the endowment diversify without giving up expected returns. They helped Gabe Sunshine and I become investors, taught us the difference between pricing something and investing in something. On that day when I was sitting there, we weren't investors. We knew how to price things, but I hadn't been an investor. What do you mean by the difference between pricing something and investing in something? How do we decide between the duration of opportunities? How do we think about how things inside the portfolio co-vary?

14:15To think hard about catalysts and holding periods. To think about the difference between capital impairment and a drawdown. All these super important things. It was a special professional opportunity. Yale became a seed investor. We rented a little office here in Boston. How long do you think it took you to go from a small team of two who knew how to price things to understanding the trade-offs that went into building a portfolio? One of the things about this business is that there's a new puzzle every day and you're learning things. It's rich and deep. It is probably not until sometime in 98 or 99 that we are fully baked investors thinking about things in the way that we would think about them now in terms of how to allocate a dollar of arbitrage capital across the opportunity set that we feel comfortable.

15:14but we know everything about in fixed income arbitrage and have a process that is detailed and allows us to compare this to that. Would I rather do something that was a longer duration for a bigger edge? Is it arbitrage? How long will it take? Is there a catalyst? How do we know this? How did it get here? What will make it converge again? It's probably someplace in that time. Somehow that was still a quarter century ago. That was a quarter century ago. As we sit here today, how do you describe the value proposition of Bracebridge as a firm? I think about the investment strategy that we're delivering to people, how it can help them meet their goals when they're building a portfolio.

16:03Our strategy is an alpha generating strategy that should allow you to diversify without giving up expected return. It should be completely uncorrelated to the general level of rates, the shape of the yield curve, equity levels, or to any currency. You can think about your asset liability management. What are my real assets? My liabilities. And this thing where you add a diversification instrument that's uncorrelated, especially to the downside, changes the profile and what your return is. you'll see that you add in 20 or 30 percent absolute return that is legitimately absolute return. You get superior total returns because you get more compounding.

16:48This diminution in vol is relevant for delivering good risk-adjusted returns. We're focused not on the firm that's Bracebridge, but on what we're delivering in terms of an investment vehicle. I'd love to tease through how you do it. This started as a firm of two people as much different today. How do you view the inputs of what it takes to deliver some uncorrelated alpha generating return stream? We're looking for inefficiencies across two things that are similar, substantially similar, or can be made to be similar through cows. Bonds are a great place to do this because they mature or they default.

17:29We try to have people become extremely expert in markets so that they can have the technical rigor from a bottoms up to understand how to price every instrument, how it's contractually constructed, how it trades, what kind of institutional vagaries there are around it. We have people in markets who are expert in those markets, but are coming at it with this different view, trying to understand how to price things correctly. What should you pay for this? We have people in structured products. We have corporates. We have an emerging market group. Then we have our oldest business, a developed market group, which is more people than we had then, more computers, more technology, doing a lot of the same things because there are still inefficiencies in developed market rates.

18:24which is incredible. What was the evolution of Bracebridge from where you started to these four areas of corporate, structured credit, emerging markets, and DM rates? Those are four stories that are all different. Structured product, natural outgrowth of being mortgage geeks. Gabe Sunshine's a huge mortgage geek, trades CMOs at Goldman, trained by a guy who can price an IOPO in Lotus 1-2-3, wind up trading the whole compendium of things that are around resi mortgage and commercial mortgage as soon as people try and put other collateral and vats that make structured product. Corporates, a little bit different path.

19:06It begins in the early 2000s when we have tranched corporate risk. Take the hundred name index, slice them up, first default, second default, third default. At that time, we trade options on them. I don't really know why it was completely necessary, but we can help ourselves. It's not just us. The whole market trades options on them. All that stuff has to be priced in a way that's coherent. The hundred names have to go together. That gives way to single-name CDS. Once they're single-name CDS, we have a bond, we have CDS, into which it's deliverable. There has to be an arbitrage relationship to those things.

19:45That is out of whack during various times. As we roll through the financial crisis, it gets completely insane. We have a lot of basis packages that leaves us with a way to immunize corporate credit risk at a single name level. We can begin to price out a capital stack. The probability that this company either defaults or pays has to be the same for every place in the capital stack. What happened after the GFC? We wind up with this pretty interesting business sometime around the GFC. Spring shoots come up, people start relevering. During that period where people are starting to relever, things come down.

20:33Interest rates are low. Central banks are keeping things low. There's many bonds issued. They're in different currencies. People who don't even have a corporate presence are issuing in countries in their currency. All this stuff leads to a lot of inefficiencies in corporates. Now we can hedge them. In IG or in risky credit, it becomes obvious to us that this is a place to do the same thing that we do the rest of the platform. EM is the gift that keeps giving. There is a general dislike. You don't want to have such a big position. A lot of people want just a little EM. There's an index. It's an emerging market benchmark index.

21:14There's dollar bonds in the index. If there's things that are outside the index, they're inefficient. We can have a pair of a U.S. dollar bond and another currency, same obligor, often defaulted, often cross-defaulted under competent jurisdiction. When you swap all the cash flows back to a single currency, they'll have different discount rates. People issue bonds with calls, with puts, with resets. All that stuff's got to get priced. It's not a place where people naturally think they can get involved without deciding they care about the credit of the country. It's been a reliable place to find alpha.

21:50Then we have our oldest business, which is rates, which is fabulous. If you told me in 1994 that I would still be finding opportunities and develop market rates today, I would have thought you were nuts. We thought, well, basis trade until we can't basis trade. Here we are. I would have expected things to become more efficient over time, but instead we have better tools, a better team with more experience, more diversity of perspectives, better path to this moment. We can aggregate a lot of information across the portfolio. We can do risk management in a more fluid way. Markets are bigger and more complex.

22:30How do you think about the potential for another adjacency coming into your core four markets? At this point, the waterfront's wide enough that most of the time when we see something, It's in the seams. People will develop instruments to help everybody manage their own financial situation. Usually, if you make something special for an investor or a set of investors, if they don't want it anymore, doesn't trade that well after they have to get rid of it. Over the course of time, when you find one of these inefficiencies, why don't the markets price them away? Why do they persist over decades? A lot of inefficiencies come from places where you have a constrained economic agent.

23:20You have investor habitat. You have market segmentation. You have somebody narrowing a mandate as a way to govern a manager. People create these indexes to meter performance. They quickly become strategies themselves. You have the ratings agencies that go into creating the index itself. Ratings are positively serially correlated. We know they're backward looking. That creates some inefficiency. We do see benchmark driven passive investing, this proliferation of exchange traded funds, which have to create and destroy things in a very mechanical way. If you add a little leverage to that, some very unusual things go on.

24:11We have some second order things that can happen. We see hurting and crowding and all the things we've seen since Kindle Burger. Whenever there's newness, new instruments, a change in the level of rates or volatility, market ownership, shifting ownership, a set of solvent guys deciding they just want to have a different amount of borrowing. Those things create opportunities. As you look at the fullness of time of doing this, what are some of the significant changes in being able to find the opportunities today than when you started? We find opportunities a lot of different ways. All of the old ways we used to find opportunities, which did involve computers and data feeds then, and still do now even more.

24:59How do you find two things that are basically the same thing and they have different prices? The way that we found is by having curious people who are expert in a market embedded and looking at everything and trying to price everything that's going on. Sometimes you find things using all those things together. Here's an example that just pops into my mind. There was a REIT that was running out of cash or they had some debt covenants. They couldn't pay any more interest, but they could still borrow money. We found them using modern techniques. It's a REIT. It's a focus on health care in real estate.

25:41They didn't have a plan to refinance a revolver. They had this rule that they couldn't pay any more interest. They were allowed to borrow money. They had unencumbered property. We ring-fenced some property, lent them the money against the property. With full disclosure and everyone knowing, we're able to hedge out whether or not this REIT survived or not by shorting another part of the capital structure. This is a joint venture between our structured products team and our corporates team. It worked out until like you're borrowing at eight and a half. You're lending to the same name at 11 and a quarter and you're secured on your long side.

26:20This one was found using some combination of industrious person with a lot of data and a way to sort through it. Some actual outgoing phone calls and sourcing of the thing. Structuring with lawyers, people who figure out how to ring fence the collateral that you want to encumber. When you surface up something that looks like an opportunity in a universe of lots of different opportunities, what goes into the research and the assessment to determine whether it's a good fit for you to put into a portfolio? First, we try to think about what is the opportunity? Is it arbitrage? Why is this happening?

27:04Is there a catalyst? How will we get out of this? Will it be the maturity or will they default? How much capital can we use up? on our pair? Do we know that from using a model? Do we know that from some first principles because maybe one side's completely unlevered or something like that? How does it compare to what we're getting paid for doing substantially the same thing in another area? That can be in another name in the same market, or it can be across the platform in a different part of the portfolio. would like to make sure that we're getting the highest risk-adjusted returns for doing arbitrage.

27:45We think that is a place where we can craft a portfolio that has good risk-adjusted returns and also take responsibility for doing that through alignment with our investors. When you go from the individual trade to creating a portfolio, how do you build the portfolio? Fundamentally, the first thing we want to do is look at things on a bottom-up basis. What is the opportunity? Then we try to look at how are these things correlated with each other? Do they come from the same force that's creating the inefficiency? Are they in the same sector? Is there some communal force that's making them correlated?

28:23And then could there be in some other world? We build a portfolio on a completely forward-looking basis, trying to get opportunities that we see, to take advantage of inefficiencies, to compete against each other, to have what we hope is the best suggested return across the portfolio on a forward-looking basis. We do a bunch of stress testing to try to make sure that we have been careful about how things will be correlated, especially in the downside case. You want to have some diversification across the thing because you want to make sure that you have buying power to do things on a crazy day when people are selling things.