While interest rates will eventually rise, there are still opportunities in certain bond funds right now, says Brad Friedlander of Angel Oak Capital.
Nancy Zambell: Good morning. My guest today is Brad Friedlander, the co-founder and head portfolio manager at Angel Oak Capital. Thanks so much for joining me, Brad.
Brad Friedlander: Great to be here.
Nancy Zambell: Tell us a little about your fund.
Brad Friedlander: The Angel Oak Multi-Strategy Income Fund (ANGLX) is a bond fund. It's composed of approximately 70% to 80% non-agency, mortgaged-backed securities, so it does tend to have a bit of a credit focus. As well, it carries a high degree of floating-rate assets. It's a lower-duration fund.
Nancy Zambell: And what kind of a yield have you been getting?
Brad Friedlander: Currently, we're in the 5% range on a 12-month running basis, and we project it will be pretty much in that range for the next several months.
Nancy Zambell: That's very healthy. I understand you had a return last year of over 20%. Is that correct?
Brad Friedlander: Correct.
Nancy Zambell: That's pretty good-congratulations!
Brad Friedlander: Thank you.
Nancy Zambell: Of course, bond funds have done fairly well in terms of inflows in the past year, because of all of the uncertainty in the economy and Europe. What do you think the direction of interest rates are going to be, going forward for 2013?
Brad Friedlander: I think rates will be relatively grounded here. We did pick up about 30 basis points or so in long-term interest rates in the last few months. And I do see that trend topping out a bit in the short-run, potentially rallying a bit lower from a rate standpoint over the next several weeks.
But I do believe investors that are concerned, of course, over the long haul, need to be very mindful of the higher interest rate environment. That's despite the fact that inflation is still relatively grounded, and we're still in very much of a low-growth environment. We need to prepare at this point for an interest rate environment that's quite higher than it is right now.
Nancy Zambell: What effect do you think the rising interest rates will actually have on the inflow or outflow to bond funds?
Brad Friedlander: I believe the majority of the traditional fixed-income world that tends to have a longer maturity and more duration and sensitivity will see outflows. In the fixed-income universe, it's probably the greatest risk that exists today.
Even though we are in a slow-growth environment, as we move away from a more of a credit environment and more of a credit crisis environment, you will see outflows out of traditional fixed income.
That's very different, though, as far as the inflows that I do expect in more credit-intensive or more credit-focused funds-those with shorter duration. The reason being that there will always be a pocket of the investor base that still demands fixed-income assets-those that may perform better during a rising rate environment.
Nancy Zambell: And do you still think the lingering effects of the recession, and of course the current fiscal cliff debates, will have positive effects for the bond market?
Brad Friedlander: I think only in the short run. I think there is still somewhat of a limit right now as far as outflows. The outflows are not significant.
But I do think, over time, as we move away from the crisis, those traditional fixed-income assets-sectors like Treasuries, agency debt, agency-backed mortgages that the Fed is basically subsidizing right now and buying more than are actually being created every day-those types of traditional sectors I think will underperform over time. I think you will continue to see outflows there.
Nancy Zambell: In your particular sector-the non-agency residential mortgage-backed securities-I've got to believe that the housing recovery is really going to be very helpful to you.
Brad Friedlander: I believe so, yes. You really have a nice combination in that sector, and that's why we've decided to have such a heavy allocation for the next couple of years, until we think that it may run its course. Certainly, in my belief, the spreads in the yields are simply too high at this point.
Then you factor in the idea that the fundamentals in housing continue to improve. Mortgage delinquencies are down a good 30% in the last two years, and home values continue to rise now at a decent clip. So it's really a sector that's not pricing in a lot of position movement in the housing market, but where you're actually seeing better information right now.
I think that's really a nice combination. I'm not seeing that anywhere else in the credit universe or anywhere else in fixed income. We're truly seeing an improvement in fundamentals, as well as in asset classes that are technically cheap.
Nancy Zambell: It sounds like a pretty good opportunity. I've read that the market is currently expected to grow to about $1 trillion. Is that accurate?
Brad Friedlander: It's currently just under $1 trillion in size now. It's basically been in a wind-down mode over the last several years, as the amount of private label or jumbo mortgages that have been created and securitized has been a de minimis number over the last few years. But that dynamic is really beginning to change now, and you are beginning to see new securitization in the markets.
There have been some trailblazers like Redwood Trust. JPMorgan is now securitizing again. So I do believe that's going to be broadly helpful-beyond just for the investment world-and we're seeing more price discovery with new-issue securitization.
It is really healthy for borrowers out there who are looking for a loosening of credit-just to a more rational level.
Nancy Zambell: Absolutely. The pendulum swings back, doesn't it?
Brad Friedlander: Yes, but hopefully, not too far...
Nancy Zambell: Exactly.
Brad Friedlander: But back to the middle is just fine for most folks.
Nancy Zambell: Right. Now in terms of prepayment risk, because interest rates being lower, a lot of people have refinanced, which has lowered the yield. Do you anticipate that's going to continue, but probably not at the pace that we have seen?
Brad Friedlander: Sure. I do think it will continue. I think there will be probably some more entry points for borrowers that are looking to refinance over the next several months.
Also, one thing that most people don't realize is the number of floating-rate borrowers that actually exist in the market right now-floating in a 2% to 3% mortgage themselves-and are not as interest-rate sensitive. But over time, they will be. If they have an inkling that the Fed is going to move, or if they're seeing interest rates rise significantly, they're going to want to refinance, even if we are drifting higher.
Nancy Zambell: What do you think the outlook for yields on these bonds are going to be in 2013?
Brad Friedlander: In the sector, non-agencies are between a 4.5% and 6% yield on average, depending on the credit quality. I believe that spread or the yield will continue to tighten. The sector is just simply too wide and not accurately priced, given the improvement in the fundamentals that we're seeing right now.
That's just a function of the sector, and many of the participants who are investing there were burned during the crisis. They're very, very conservative at this point, and don't want to be burned again.
I think as we see more rational thinking, as we see the data flow in to most models and the way that investors are banking in yields, we're going to see those yields fall over time and prices rise in this particular sector. That's why we're so high on it.
Nancy Zambell: Even if the yields do fall a little bit, they're very healthy compared to what you can get at your local bank, right?
Brad Friedlander: Yes, absolutely. Of course, it does involve some degree of credit risk. If you are very deliberate about that credit risk and have a good sense of the industry that you're involved in, it could be managed.
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