Angel Oak Capital Advisors' Sam Dunlap talks value in non-agency MBS

Atlanta-based Angel Oak Capital Advisors’ flagship multi-strategy income fund (ANGLX),  this year celebrates its 10-year anniversary.  The ANGLX is a dedicated structured credit mutual fund, focussing chiefly on US non-agency residential MBS, and was launched after the Financial Crisis of 2007/2008. In the last decade, ANGLX has achieved average annualised returns of 5.66%, as of 6/30/21, and now has approximately $7bn under management. Sam Dunlap, chief investment officer of public strategies, talked to US editor Simon Boughey, who is also based in Atlanta, about the state of the structured credit market, where he sees value and where he doesn’t.

Hi Sam, how are you? So, looking back ten years ago, in the wake of the sub-prime crisis it can’t have seemed the most obvious move in the world to start a fund dedicated to US structured credit. Why did you do it?

It was definitely unique. As you know, 2011 was a challenging time in the credit markets but also an excellent opportunity. A lot of our initial core investors were looking for an open-ended opportunity within structured credit and that was the genesis of ANGLX.  We have a US structured credit focus, predominantly mortgage credit. In our view, there was a need for this, and there continues to be so, as we see structured credit as generally continuing to be under-allocated. In our opinion, this bodes well for the next decade of growth and potential performance.

The fund focus is everything non-agency, so RMBS and CMBS, as well as CLOs, but it is predominantly a mortgage credit fund. Historically we have allocated the bulk of the capital to non-agency RMBS and, in our opinion, this has represented an overwhelming opportunity over the last decade. We continue to hold that conviction about RMBS.

What is the governing investment philosophy underpinning ANGLX?

Our philosophy to identify the best relative value within US structured credit that in our view will deliver superior risk-adjusted returns over the full credit cycle. We feel non-agency RMBS is still often misunderstood from allocators who continue to look back at the Financial Crisis of 2007/2008, and understandably so, but in truth the non-agency structured credit market is very large with lots of different components. It’s a $3trn asset class. It is a nice complement for investors looking for high current income and shorter duration.

Spreads are really compressed at the moment. Where do you see value?

We still favour non-agency MBS particularly senior legacy assets. That is an area that still provides yields at swaps plus 120-150bp, depending on your scenarios. The bulk of the asset class is still at a healthy discount. Prepayments are at historic highs and housing value tailwinds are pushing yields into much more bullish scenarios, with often optional upside as well.

Specifically, we favour assets in the RMBS 2.0 space, namely prime jumbo subs and some areas of mortgage insurance. Prime jumbo subs were hard hit after the Covid crisis especially as mortgage REITs were selling. We saw this and still see this as a huge opportunity to get access to America’s best borrowers in the form of prime jumbo subs and mezzanine tranches. We like that area not only from a perspective of current income but also total return potential in the form of spread compression.

What about the CRT market? Do you like that?

We do like the CRT market. This is compelling from a spread perspective, and also because CRT assets are floating rate. You’re getting high spreads on a relative basis and we also like the fact that the fundamental mortgage credit tailwind is bolstering total return potential as well.

What we favour are seasoned tranches of agency CRT, the CAS and STACR programmes, and mortgage insurance CRT, the ACIS and CIRT programmes. Despite the thinness of yields on a relative basis, when you factor in home price appreciation and the prepayment story, and also where we see delinquencies right now, it is in our view an attractive opportunity. But we favour and continue to favour more seasoned tranches of both agency CRT and mortgage insurance CRT.

Do you look outside the US for CRT exposure?

No. From the beginning the focus of ANGLX has been US structured credit and predominately mortgage credit. That’s what we do and we’ll stick to our knitting going forward.

What about US bank CRT deals?

We have looked at them and while so far we haven’t been a huge participant we do see it as an area that will expand and it will be in our view be an attractive opportunity in the coming years. US banks can benefit from the success of CAS and STACR. I think the performance of the mechanism over the years shows there is clearly demand in the marketplace and acceptance of the structure. And we think it could be a win-win for not only the issuers, but also bond market participants like ourselves.

Will US banks issue more CRT do you think?

I wouldn't say it's necessarily something we've been hearing, but there is definitely a growing acceptance of the structure. Among money managers like ourselves there will be a continued need for this type of deal. I think really the $64,000 question is what do US banks want to do? Do banks actually want to get rid of that credit exposure or is that something that they would rather keep on balance sheet

We’ve touched on this but how is increasing prepayment risk enhancing MBS value?

How we're positioned within the non-agency portfolio is definitely benefiting from the prepayment speeds. This notably is the case in the legacy portion and is still at a discount. Higher than expected prepayment has been very beneficial, not only to current income, but for potential spread tightening.

We think mortgage credit tailwinds have been blowing quite hard but we expect them to continue particularly for the second half of the year. We think the Fed will stay firm. The portfolio continues to benefit from the high prepayment risk.

What don’t you like at the moment?

We’re not in favour of owning agency RMBS at the moment because of very high dollar prices and low all-in low yields, but also from an OAS basis they don’t make much sense from negative convexity standpoint. We just don't see very much upside from here and definitely favour non-agency assets.

In general, we are wary of taking a lot of interest rate risk at all-time low yields. We’re broadly cautious of long duration in favour of higher current income and shorter duration characteristics that you get in other areas of structured credit.

We’ve always tended to favour solid credit fundamentals and areas of the structured credit markets that would pay us over the long credit cycle.

Thanks Sam. That’s been very interesting. Let’s grab a coffee in town soon!

Simon Boughey