Bond investors are always trying to maximize income without taking on too much risk.
The Angel Oak Multi Strategy Income Fund has been able to perform well with a fascinating strategy that includes buying discounted mortgage-backed securities issued before the 2008 credit crisis — and this strategy may bode even better over the coming years.
The $6.6 billion fund
gets four out of five stars from Morningstar. Before getting into the fund’s strategy, here’s how its two share classes have performed against their Morningstar category and the fund’s benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index:
|Total return – 2018 through March 12||Total return – 2017||Average annual return – 3 years||Average annual return – 5 years|
|Angel Oak Multi Strategy Income Fund – class A||0.0%||5.4%||3.1%||3.6%|
|Angel Oak Multi Strategy Income Fund – institutional||0.0%||5.7%||3.4%||3.9%|
|Morningstar Multisector Bond category||-0.6%||6.1%||3.2%||3.0%|
|Bloomberg Barclays U.S. Aggregate Bond Index||2.1%||1.9%||1.3%||1.8%|
|Source: Morningstar Direct|
The fund’s class A shares were established in June 2011 and the institutional shares in August 2012. You can see that the five-year returns for both share classes have been competitive.
The class A shares have a 30-day yield of 4.52%, while the 30-day yield for the institutional shares is 4.88%. In comparison, the 30-day yield for the SPDR Portfolio Aggregate Bond ETF, which tracks the Bloomberg Barclays U.S. Aggregate Bond Index, is 2.99% and 10-year U.S. Treasury
have a yield of 2.86%.
Discounts and credit quality
A bond’s interest rate is based on its face value. If you purchase a bond in the open market, it is likely to trade at a premium or a discount to the face value. All things being equal, the price of a fixed-rate bond will fluctuate in the opposite direction of interest rates. But a bond may also trade below face value if some investors shy away from it because they believe the risk of default is too high.
According to Sam Dunlap, a co-manager of the fund, about 62% of the portfolio is made up of non-government-guaranteed mortgage-backed securities that were issued before the credit crisis. And those securities have been purchased at an average discount to face value of about 15%.
That discount means the fund eventually will realize gains on the bonds as they mature. In the meantime, however, if interest rates continue to rise, the bonds’ market values will decline and that will be reflected in the fund’s share prices (as it has two share classes).
But in addition to the eventual gains as bonds mature or are paid off, the discounts exceed the fund managers’ expected default rates on bonds made during the heyday of the housing boom.
In an interview on March 7, Dunlap said bond portfolio managers generally expected losses on these bonds to run “anywhere from 3% to even as high as 6% to 7%.” Those might seem to be high potential loss figures, but they are far lower than the average discount on the legacy mortgage-backed securities held by the fund.
When asked if the aging of the underlying loans, the recovery of home prices and refinancing activity have limited the supply for managers looking to purchase pre-crisis non-agency mortgage paper, Dunlap estimated that from a peak of about $2 trillion, the securities had amortized down to about $475 billion. So there’s still plenty for the fund to invest in.
He also said he is “finding good opportunities in the new non-agency market in the U.S., which is showing new signs of life” amid strong housing demand.
Dunlap sees plenty of additional upside to the U.S. housing market because of pent-up demand. “The stock of new homes for sale is about 20% below long-term averages,” he said, and he expects home prices to continue rising between 5% and 6% a year.
“That is a healthy backdrop to our legacy RMBS [residential mortgage-backed securities] holdings and mortgage credit, generally speaking,” he said
Protection against interest-rate risk
According to Dunlap, about 60% of the Angel Oak Multi Strategy Income Fund is invested in floating-rate securities. This means that bonds held for the fund will periodically reprice as interest rates move up or down. In a rising-rate environment, this is especially sweet. Not only does it mean income will rise, it means there is another layer of protection against the decline in market values of fixed-rate bonds as interest rates rise.
In a rising-rate environment, you will see headlines in the financial media saying “sell your bonds now!” However, if you hold individual bonds until they mature, you will be repaid the face value (barring default). So as long as you do not pay a high premium for the bond, or do so only if you determine that its high yield and years to maturity make the premium worth paying, you don’t need to worry about day-to-day market value fluctuation if you hold the paper until it matures.
Tolerating price fluctuations
When holding shares of a bond fund, the share price fluctuates as the market values of the fund’s bonds fluctuate. Yes, the bond fund will be “made whole” as bonds mature or are paid off, but it can be very painful for investors to wait out the rate fluctuations. This is why you must have a clear objective before investing in a bond fund or buying your own bonds. The objective is current income and capital preservation. If you are patient and don’t sell into a declining market, you are very likely to achieve your objective. If you react to the headlines, you might make a very painful mistake.
Also see: These real estate fund managers show there’s money to be made as rates rise