Angel Oak: Income with Rate Protection

Brad Friedlander’s Angel Oak Multi-Strategy Income Fund has outperformed its bond market benchmark by focusing on non-agency mortgage-backed securities and floating rate positions; here, he explains his goals of preserving capital and generating solid returns.

Steve Halpern: Joining us today is Brad Friedlander, founder of Angel Oak Capital and head portfolio manager of the Angel Oak Multi-Strategy Income Fund (US:ANGLX). How are you doing today, Brad?

Brad Friedlander: Doing great, Steve. Great to be here.

Steve Halpern: Angel Oak Multi-Strategy ranked in the top 1% of its category in 2012, and last year it returned nearly 4%, while the Barclay’s Aggregate Bond Index lost money. What do you credit the strong outperformance to?

Brad Friedlander: I think it’s our focus on, really, the most undervalued assets that we can muster in the fixed-income world and the bond world.

We tend to focus on more credit-related investments, namely, the non-agency mortgage-backed securities market that was once viewed as toxic and, gradually, the investor community is warming up to the idea that there is potential value in those types of assets.

We still believe that they’re significantly undervalued across most of the areas of the structured credit markets, and so, we still believe that there’s value there. At the same time, we tend to focus, up in quality, on the higher quality aspects of the structured credit universe, and with that, preservation of principal is still one of our key tenants.

Steve Halpern: As background, what’s your current outlook for the overall economy and what do you expect from the Federal Reserve as the year progresses?

Brad Friedlander: We’re still climbing out of the winter doldrums. The market spent the first quarter really reacting to a lot of the geopolitical risks.

If you remember, the threat of a currency crisis in the earlier part of the year, and a lot of softer economic data that was really tied to weather, and I think we’ve begun to reverse out of that some. We’ll continue to watch and monitor some of the labor market related data that’s coming out as far as jobs are concerned.

That should be more beneficial, especially if you look this week, we had some figures on jobless claims again coming down a bit.

We’ll be watching growth figures as well. I think there’s still the potential for the economy this year to flirt with near 3% growth, but again, it’s still going to be a very gradual recovery that we’re seeing now. The Fed is keeping a watchful eye as well and they are near robotic in nature, I think, and just not overreacting to any one data point.

They are looking at the series and anyone trying to overly read into any sort of bias on the part of the Fed or any sort of sudden changes, I think, have been proven wrong over the course of the last six to 12 months.

Steve Halpern: You’ve cautioned that there are longer term risks to those who hold US Treasuries, and you note that the environment has bailed out the bond market in our recent times and you see this momentum reversing. Could you expand on that?

Brad Friedlander: I think interest rates—the ten-year—at this point, is roughly 2.6%. That’s a good 40, 50 basis points below where we were in the beginning of this year. This is falling largely into our forecast for the first and second quarter, so we may have a few more weeks or months of generally lower rates.

At some point here, we do expect the weight of better economic data potentially as well, some more confidence in the broader markets, removing some of the uncertainty and some of the geopolitical risks that are still out there. We would expect that trend to reverse.

We’re at a point now where, with Treasury sitting at such a low rate, and much of the traditional bond market sectors and subsectors at such low rates now at this point, one needs to look at the risk/reward, I think, of both and that relationship there.

Just a 40 or 50 basis point move higher in interest rates back to where we were in the beginning of the year could result in a 3% or 4% drop in valuation for many of those traditional type of fixed income products. It’s something that we are wary of.

We tend to look at the credit markets and we think that investors are rewarded by taking a marginal degree of credit risk within fixed income. That is the best way to transition to a point where the Fed is less accommodated then they are now and we’re in a higher interest rate environment then we are now.

Steve Halpern: You’ve been bullish on floating rate assets. Do you still see that as an opportunity in the current environment and looking forward?

Brad Friedlander: I continue to see value in floating rate assets. I like to remove as much of the interest rate speculation that’s really embedded in a lot of fixed income investing that goes hand-in-hand, traditionally, with being a fixed income investor is taking interest rate risk. We like to remove that as much as possible.

The way we do that is by focusing largely on floating rate assets. Our fund, the Multi-Strategy Income Fund, is a good 60%, 70% floating rate and with that carries a lot less interest rate sensitivity.

So, what I like to give our investors is a much cleaner look and a way to participate in an improving economy, an improving housing market, one that’s improving very gradually and be less tied to interest rate speculation or the threat of a large spike in rates.

Steve Halpern: Speaking of the housing market, your fund is overweight in non-agency residential mortgages. Could you tell us a little more about your reasoning behind that position?

Brad Friedlander: We’re seeing, I think, what I call a “killer combination in fixed income,” but particularly in the non-agency market. These are credit-related investments and loans that are residential in nature, so these are just home loans that have been pooled into securities.

We tend to focus on older vintage securities that were originated pre-crisis. That’s an area that we have seen a real nice combination of improving fundamentals. You’re seeing delinquencies down considerably over the last several years.

The collateral backing them, meaning the homes themselves have risen from a valuation standpoint as home prices have come up, and that’s a function of a drop in inventories and just fewer distress sales across the US. We’re really seeing a nice combination.

The borrowers themselves have also improved their balance sheets; have improved dramatically over the last few years. That’s an area that we really like, that combination of that fundamental improvement, at the same time, though, being very technically cheap, in our opinion, with yields that are still available north of 5%.

It’s an area that we continue to focus on. We believe that there’s still value there and it allows you, as I mentioned earlier, to make a clearer credit—more of a credit-focused investment—rather than an interest rate focused investment.

Steve Halpern: Within this low rate environment, what type of return should an investor be able to expect from your fund. What are you looking for as the year goes forward?

Brad Friedlander: I challenge myself and our team to, beyond the dividend yield, which is currently in the range of approximately 5%. We don’t expect any significant differences there based on our forecast over the course of the next several months.

We do believe these assets are undervalued and there’s the potential for upside appreciation. Over time, valuations can move, of course, in either direction, based on the macro economy, but we do believe these assets are largely undervalued.

As interest rates eventually climb as well, we do believe that many of these assets will actually outperform, which is quite contrary to what most people would expect in the land of fixed income.

Steve Halpern: Would you say that this fund is suitable for a conservative low-risk investor?

Brad Friedlander: I believe so. That is how we’ve designed the fund.

Steve Halpern: Thank you for joining us. We really appreciate you taking the time today.

Brad Friedlander: Great to be here. Thank you.

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