Fixed income used to be perceived by many as a “boring” asset class, but after the last twelve months, most investors realize that it is “anything but.” Yields are dramatically higher, and some analysts are even putting forth the case that “40/60 is the new 60/40.”
Colin McBurnette, senior portfolio manager at Angel Oak Capital Advisors, joins the show to discuss the structured credit market, and why many so High Net Worth investors are allocating increased capital to this unique asset class.
Episode Highlights
- Background on Angel Oak Capital Advisors, and Colin’s career in the credit sector.
- Analysis of Angel Oak’s 2023 Market Outlook, especially its insights on how some HNWIs are changing top-level portfolio allocations.
- Insights on long term demographic trends, and how the “demographic downward spiral” in the West may not provide enough deflationary pressure to overcome upward inflationary pressures (at least in the next few decades).
- The appeal of the structured credit asset class, and why it holds the potential to generate enhanced returns.
- Details on ASCIX (Angel Oak Strategic Credit Fund), and why the firm structured this product as an interval fund.
Featured On This Episode
- ASCIX – Angel Oak Strategic Credit Fund (Angel Oak Strategic Credit Fund)
Today’s Guest: Colin McBurnette, Angel Oak Capital Advisors
- Angel Oak Capital Advisors – Official Website
- Angel Oak Capital Advisors on LinkedIn
- Colin McBurnette on LinkedIn
About The Alternative Investment Podcast
Hosted by WealthChannel co-founder Andy Hagans, The The Alternative Investment Podcast is the #1 alts podcast reaching RIAs, family offices, and High Net Worth investors.
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Show Transcript
Andy: Welcome to “The Alternative Investment Podcast.” I’m your host, Andy Hagans. And today, we’re talking about structured credit, a very popular asset class, increasingly popular, I should say. And I’m very happy to announce that joining me today is Colin McBurnette, who’s Senior portfolio manager at Angel Oak Capital Advisors. Colin, welcome to the show.
Colin: Thank you, Andy. Nice to be here.
Andy: And we have a lot to talk about today. Structured credit, I mean, it’s huge in alt. I mean, it’s increasingly a part of high-net-worth investor portfolios. And we also wanna talk about the macro picture a little bit, but why don’t we start with you and your background and what you do at Angel Oak?
Colin: Sure. I’m a senior portfolio manager here at Angel Oak Capital Advisors space in Atlanta. I oversee all the residential mortgage credit investing that we do within our public funds complex, as well as within our separately managed account business and our hedge fund. Prior to Angel Oak, I was at Wachovia working in their CMBS group in the pre-crisis period, or pre-global financial crisis period. And then spent a few years in a distressed debt startup in Atlanta before joining Angel Oak in 2012.
Andy: So, let’s see. You’ve been in this kind of credit world since before the financial crisis, would you say? How many market cycles? Again, let’s time, not in years. How many total credit market cycles have you been through?
Colin: Well, we’re coming on 16 years now. But I guess it would depend on how you would define a cycle. You know, March 2020 on its own, you know, felt like we lived the full cycle from peak to trough in a couple of week period. So everything, you know, heading up into the global financial crisis period through, unless maybe we define the start of QE as the beginning of a cycle and quantitative tightening as the official end of that one. So, you know, here we are kind of heading towards what is realistically the first, you know, potential recession that the US has faced since the global financial crisis.
Andy: Yeah, and it’s interesting, you kind of alluded to this, how do we even define a cycle? Because to your point, it felt like 2020 was almost a one-year cycle. like, you know, the whole cycle in a year. There was the financial crisis 2008, 2009. And to me though, it almost feels like the macrocycle in credit and inflation, it’s arguably like 40 years or something. If I really zoom out, I could say we’ve been deflationary for so long that even having a year or two of sustained higher inflation, it’s like… You know, I’m 39, I don’t have the muscle memory to deal with this. I wasn’t around in the ’70s.
Colin: No. Most people sitting in the seat today making decisions, especially in fixed income, have never traded through or managed money through a sustained bond bear market, and we got that in 2022 for the first time in most of our careers.
Andy: You know, an interesting thing to stay on inflation for a second and interest rates, I have like two theories that are intention inside me right now on inflation. And the one theory is, there are structural issues in our economy right now that point to higher inflation sticking around, you know, supply chain, tightness in the labor market, just structural things that I don’t think have gone away. I know we’re seeing disinflation starting to set in, and I think that will play out, but personally, I don’t really see disinflation, like things going back to the way they are. That’s kind of the near-term midterm picture.
But I also see there’s all these longer-term trends that are deflationary, you know, in terms of demographic trends, in terms of… I don’t think globalization is gonna totally reverse itself, you know, innovation, technological efficiency. So it’s like, even in myself, I can’t decide which of these two kind of big picture things, these structural issues causing inflation to sustain or the really zoomed out kind of long-term thinking. I still feel like things are deflationary when I really zoom out far enough. What do you think?
Colin: You know, we’ve had that debate a lot over the past few years. You know, heading into, let’s say through 2019, I mean, there were a number of things you could point to that were particularly disinflationary, as you highlighted, demographic trends in the US, slowing birth rates, things of that nature. But I think one of the trends that’s emerged and shifted our thinking towards us being in, you know, call it a decade-long inflationary environment, and that’s not to say that we won’t, you know, get some benefit from the data this year and, you know, and roll back towards the Fed’s goal, perhaps giving them, you know, justification to take their foot off the gas pedal here. But we do think that number starts to trend higher again.
And a big component of that is the labor force dynamics that exist, especially with the conflict that we have now in Europe and kind of the shut… Whether it’s, it’s both changing demographics broad as well as, you know, somewhat of a shutting off of the West from you know, from the labor force that had existed in Asia and in Russia over the past several decades. I think it’s gonna have a pretty big impact on cost of labor and ultimately cost of goods and have a very inflationary impact on its own.
Additionally, and if you go back to the 1970s, you had the largest generation in history in the form of the baby boomers come home from the war in Vietnam, and then really start to kind of get down to it, if you will. They began forming households at a rapid pace. They hit the kind of peak years when you tend to get into that time in your life, when you start buying a house, you tend to be on an upward slope from an earnings perspective, you start adding leverage, typically in the form of a mortgage, but also in credit cards and other ways, and that tends to have a very stimulative, inflationary impact on the economy.
And you could draw a lot of corollaries to what we saw from a demographics perspective then to what we’re seeing now with the millennial generation effectively kind of coming home from the war on COVID, if you will, entering that very same part of their lives. They are the largest generation to come through this part of the curve. They’re larger than the baby boomers. Then you’ve got the leading edge of Gen Z not far behind them, and they’re projected to be slightly larger or at least as large.
And so I feel like you’re gonna push, you know, a very large portion of the population through those kind of peak years for formation and productivity and leverage over the next two decades. And that, I think, is gonna have a pretty inflationary impact in terms of in terms of what it does to the US growth picture.
Andy: Well, that’s really interesting. And to your point, to me, the demographic thing, again, it matters, how far do you zoom out, I suppose. And I’ve heard that story, you know, with millennials, the largest wealth transfer in history, you know, coming of age, household formation. It sounds like Gen Z might be even bigger. But one piece of this I don’t understand is, okay, the birth rate is 1.6, but I keep hearing each generation is bigger than the last. I’m like, “Well, how is that possible?” Is it the case that, you know, there’s like a 30-year lag or 40-year lag between the birth rate and this household formation that’s happening when millennials are in their 30s? Or is it more that immigration is more than filling in the gap, in a lot of good ways economically?
So part of me feels like maybe this comes down to immigration, if, you know, you look at the country’s population, fast forward the next 100 years.
Colin: Yeah. You know, there is definitely a lag from the birth rate to its impact. And that’s definitely something that’s notable. I think right now, you know, the immigration environment in the US is such that we’re not bringing in anywhere near as many people as we used to. And by some economists, we’re near enough to make up for that decline in birth rate. A shrinking population is a definition for, you know, a slowdown in growth. And, you know, that could create whether it’s a Japan effect over time.
It’s definitely something that we’re watching though, that is, to your point, incredibly long-term. And you’ve gotta zoom pretty far out to be, I think, focused on that impact. And as long-term investors, we’re something that we clearly think about, but I would say that our focus from an investment perspective tends to be you know, much more near sight.
Andy: Let’s let the endowment portfolio managers worry about demographic trends 100 years ago. Right? Like, for you, for me, for a listener, for an advisor, it’s really the next 30 years, I guess we can call that long term. It’s not very long-term, but we’ll call it long-term. And on that note, so it sounds like in general, I’m hearing Angel Oak, you all believe that this higher inflation is gonna stick around, right? There may be some disinflation, but we’re probably not gonna get back to, you know, 2% long-run inflation target indefinitely. Is that fair to say?
Colin: We think we’ll touch it, but we don’t think we stay there.
Andy: Understood. So, on that note, I downloaded your 2023 market outlook, and there was a lot of interesting stuff in there. One section that really popped out at me, and it made the CMO and me smile, you know, my marketing guy, our bonds, the new stocks 60-40 to 40-60. And I just smiled because I’m like, “This is the gauntlet being thrown down.” So let’s talk about this. This is a really big-picture idea that the 60-40 is now 40-60. What do you mean by this?
Colin: Sure. With rates, having, with that, you know, 40-plus-year bull market for rates that you defined out of the gates, and then, you know, with where rates were in the post-global financial or certainly post QE period, you know, if you wanted high-risk premium stocks were the place to go get, you know, excess return and be able to keep up with whether it was spending goals in the endowment side or, you know, or saving for retirement and trying to achieve some goal, you tended to have a relatively large allocation for stocks. And stocks certainly benefited handsomely from the lower rate environment.
But when we were assessing the landscape looking forward after last year’s bond bear market, you got to the place wherein in high quality, oftentimes investment grade rated cash flows, you were seeing yields that looked a lot like what equity returns were expected to be in the high single digits, you know, from a total return perspective, you know, possibly into the low double digits. And I think that sort of return profile when you’re able to do so in bond form with a defined duration and a seniority in cash flow versus what you would find in the equity markets, we thought would really stand out to investors, to retail investors and institutional investors alike.
And you start to see people shift dollars towards fixed income saying that, “Yeah, this premium is now enough for us to reallocate towards it. We don’t have to take, you know, the bottom of the capital structure risk across our portfolio to achieve our return targets.” And I think out of the gates this year, we’ve started to see that. Looking at, you know, anecdotal flows across different wealth platforms, you are seeing more of a shift towards bonds or towards fixed income than you are towards equity, at least as people are looking at redeploying cash in the first quarter so far of 2023.
Andy: Yeah, it makes sense. I mean, to me, we got to a certain point, and maybe Japan illustrates that maybe you never get to that point, but bonds are yielding, they were yielding such a low amount and fixed income felt to me like it was yielding such a low amount. I’m just like, “Where could this asset class really go?” It feels like it’s outta ceiling, you know? And I guess it can always go a little higher, but it has to be close to a ceiling. And in hindsight, it was kind of like a simple obvious, almost a dumb thing, and it was true.
And now, you know, with bond prices having fallen, interest rates are way higher, well, that means the opportunity in fixed income and structured credit, all these forms of credit, the opportunity is a lot more appealing now, right? It’s just like when cap rates expand, it’s like, “Great, if I’m not selling this year, that’s great.”
Colin: Absolutely.
Andy: So this is teeing up maybe the next bull market or the potential for outsized returns. Maybe a better way to put it is you know, to your argument, a better risk-return profile for credit, because now, it feels like credit’s playing a little more offense when you’re hearing about products and strategies returning 9, 10, 11, 12%. It’s like, “Wow, this is what people used to talk about in the ’70s, you know, with fixed income. And you think back to like PIMCO and some of these kinda legendary companies. And all respect to PIMCO, but you kinda look back and go, “How much of their growth was just riding this incredible wave, picking the right wave that’s worth a lot?”
But the market outlook, it also referenced… So here’s my other thing, it referenced the 60-40, and you kind of flipped it and said it’s the 40-60, but are we still even living in that world? I’m biased, you know, the, I’m the host of “The Alternative Investment Podcast,” we go to all these industry conferences and there’s all this, you know, buzz with RIAs, with family offices, with, you know, fund managers. It’s the 50-30-20 now, or, you know, whatever their model is. So, the idea is that the 60-40 is dead. I guess, how do you square that? Are we in the, are we in the decade of the alt now? Is there space for the 20? Is that kind of another way to state the 40-60 thesis that you guys stated?
Colin: I think so, because looking at… Well, I guess two thoughts on that statement. One is, we see the same, we see the same trends. As you can imagine, as we go out and meet with existing clients or prospective clients of ours, we’ve seen a meaningful shift towards, or an adoption of more alternative products with everyone’s portfolio. I do think when thinking about alternative products, they’re ultimately investing or expressing, you know, the same view that you’re getting, whether it’s in fixed income, you’re either senior secured or potentially unsecured, but, you know, in a debt position within that capital structure or an equity position within that capital structure.
So, I think it’s a different way of slicing that 40-60, if you will.
But ultimately, you can map those alternative products back towards their ultimate, the ultimate market in which they’re trying to replicate.
Andy: Understood. Okay. And I want to get to some of your funds here in just a minute, but, you know, to zoom out a little with this asset class, we’re talking about structured credit, right? That’s what your firm is known for. So could you talk just a little bit, you know, to any listeners who aren’t really aware, well, what’s structured credit, what is structured credit? And, you know, sort of broadly, why does it deserve a place in my portfolio if I’m a high-net-worth investor?
Colin: Sure. So structured credit is 6% of US fixed income, or non-government guaranteed structured credit is 6% of US fixed income. The agency mortgage market which kind of gets wrapped up in it is the second largest and second most liquid market in the world behind US treasuries. But the non-government guaranteed portion is about 6% of fixed income. And it’s split relatively evenly between residential mortgage-backed securities, commercial mortgage-backed securities, asset-backed securities, and collateralized loan obligations. So it’s a world of acronyms but it offers…
Andy: And are those broadly all the things that blew up in 2008, 2009?
Colin: They are. They are. Absolutely. The RMBS or the residential-mortgage-backed security world was the center of that storm. I could take you down a rabbit hole in terms of what happened from a ratings perspective and its impact on bank capital ratios. And we effectively, in a period of a few months going into the global financial crisis, the high-yield bond market was about 750 billion of outstanding securities. The RMBS market alone saw a little over $2 trillion of bonds downgraded from AAA to junk in a matter of months.
So if you could imagine creating out of thin air, you know, a new high-yield market that’s over three times the size of the existing one, that has an incredible impact on prices and ultimately had a number of ripple-on effects that clearly have taken us decades to repair. But yes, it is largely what blew up the world. Most people know about it from the movie, “The Big Short.” It’s where they’ve gotten most of their baseline knowledge for US structured credit.
But, US structured credit has a lot of benefits relative to other fixed-income products that I think make it… It is a reason why you see it typically overallocated in institutional portfolios. It is often under-allocated in…
Andy: Well, hold on. Hold on. I wanna stop you there. It sounds like either that means that the smart money likes this asset class, or maybe it means the risk-return profile kind of aligns more with institutional goals, or maybe both. Why would you say institutional are kind of more overweight this class?
Colin: You tend to get compensated quite a bit more for the relative complexity of structured credit than just call it corporate credit at each point in the ratings spectrum, so whether you’re investing in AAA, As, BBBs, BBs, you tend to always be compensated more for owning structured credit than owning similarly rated corporate credit. You also have credit enhancement, or you tend to have securities beneath you to absorb losses. So as opposed to, for example, a high-yield security where the bot either pays off or it doesn’t and at which point you go into to some sort of workout with the issuer, and in which you hope to recover all of your cash flow, which may not.
In structured credit, you tend to have securities underneath you that absorb those losses. So it tends to be a much slower degradation of credit than what you would see elsewhere. So, I think it’s the additional compensation, helps a lot. And you do get paid more, you get paid a liquidity premium, which I think is really why when you go back to, you know, kind of our impetus for launching our interval fund, which I know we’ll talk about here in a little bit, part of that was that vehicle is tailor-made to capture those securities that do offer that additional liquidity premium. So it kind of magnifies what you’re being compensated for comparable credit risk elsewhere in markets. And I think that’s why we see institutional allocations towards it, and why we like it as an asset class.
Andy: So, it’s a little bit more opaque. I mean, not really, but perception of it, it’s a little bit more opaque. It’s perceived as a little bit more complex. And it has an illiquidity premium. I mean, that’s pretty much a recipe for alts investing, right? That’s kind of the macro thesis on the IV portfolio, and to your point, these institutional investors. So, I mean, that does kind of sound like my first suggestion. It’s more that the smart money is saying we can put our capital to work, get a little extra return for occupying a similar part of that risk-return profile. That’s the name of the game.
So, now I want to talk about one of your specific funds, and I’m gonna pull this up on my show notes here. And by the way, I’ll make sure to also link to this fund in our show notes. But I wanted to ask about ASCIX specifically. So, this is the Angel Oak Strategic Credit Fund. Could you tell us a little bit about the strategy behind this specific fund?
Colin: Sure. So, this is our strategic credit fund, which is an interval fund that we launched at the end of 2017. Within it, we invest in an attempt to maximize returns across a full cycle in US structured credit. We try to generate high income as a primary component of that investment strategy and also seek as a secondary component principle appreciation.
Andy: Okay. So, I guess, where does this fit in? If I’m a high-net-worth individual investor and I’m thinking, “Okay, I want to get more… ” Maybe I’m increasing my allocation to credit, or maybe even just within my allocation to credit, I want more income, I want more potential for capital appreciation, I want the opportunity for return. Is this fund actively managed? You know, how diversified is it? I guess where does this kind of a fund fit in with my overall, you know, fixed income or credit allocation? And I’ll preface it with the disclaimer, neither of us are financial advisors, insert disclaimer here, etc., etc..
Colin: I guess to take, call it one step back before I answer that specifically, and that’s that I think retail investors tend to, and high net worth individuals, tend to overvalue the liquidity of their investments. And so, you see all the time, specifically within retirement accounts, people own a lot of daily liquid strategies. And so you’re paying for daily liquidity even though you can’t really, as an owner of an IRA, you know, potentially withdraw capital from that vehicle for upwards of 30 years, depending on your age and when you began investing. And so I personally think that you should be willing to lock that capital up or get paid more for the duration of that capital, which is what institutions are so good at.
Andy: I think you nailed it with the IRA point. If this is in my taxable account and I have the liquidity, because I might wake up tomorrow and wanna buy a boat, and okay, I’ll liquidate this ETF and go buy a boat, fine. If it’s in my IRA, then why should I pay a liquidity tax for the next 30 years when I don’t even need the liquidity? I’m choosing to pay this tax. It’s silly.
Colin: Correct. And especially when I’m making, you know, fixed income investments, you know, if you’re looking at holding an investment in a fund for, you know, the duration of that fund, now, funds are open-ended and they continue to roll. But if you’re thinking about making a multi-year investment, I think you should be paid for that multi-year hold period. And I think interval funds and other illiquid investments, which you talk about on your podcast, enable you to do that. They enable managers to hold less cash. Therefore, you know, concentrating the return stream that you’re receiving and their, you know, best ideas, it protects you against other investors selling if they’re not as convicted as you are, which is something that you see all the time occur in more liquid products.
Also, I think interval funds are a really nice alternative relative to things like hedge funds and private equity vehicles because you get some of the same regulatory framework that you find in open-ended and closed into mutual funds in terms of limits around duration, limits around derivatives, things that kind of come out of left field as it were, and often create permanent impairment within investment vehicles. As an end user of an interval fund, you’re protected to a much greater degree from those sorts of things in an interval fund structure as opposed to, you know, a traditional LP hedge fund like vehicle.
Andy: Yeah. So, that makes sense. So, essentially, the thesis with this product and this asset class is, look, you know, depending on your portfolio and your portfolio goals, if you don’t need the liquidity, don’t pay the liquidity tax. Or maybe to flip that and state it in a more positive way, if you can afford the illiquidity, go grab your illiquidity premium, right? I’m all about, like, my whole investment philosophy is triple net returns. And my thing is, I know I’m not the next Warren Buffet, you’re not in the next Warren Buffet. Nobody’s the next Warren Buffet or maybe one person on earth is, okay? But the point is, there are all sorts of easy little wins you can get just having just tax efficiency, right? Usually, just by being tax efficient, you can lock in an extra 100 bits of return every year, but it’s like, that’s boring.
So, investors are like, “Well, that’s boring though. I want to think I can pick the next Tesla.” I’m like, “No, I’m pretty sure I’ll take a boring win and then stack, you know, win after win.” So, I think the idea that you’re alluding to, it’s the IB portfolio, is if you can get extra alpha, if you look at your overall portfolio, you know, if you take a very high net worth, ultra-high net worth family office type portfolio, within every asset class, if you don’t need to be liquid, you can afford to go illiquid. If you can, you know, have high-quality assets, high-quality managers, that’s a big gift. But if you can, then you can get extra return, you can enhance returns in every single asset class in that portfolio, you know, according to, like that Yale portfolio model. Would you agree with that?
Colin: I would. I think, you know, you made a couple of good points, which one is picking high-quality managers. And I think once you do, and if you have conviction around whether it’s an asset class overall, you know, there’s been a lot of work done around the compounding impact or how the impact of you’re missing out on whether it’s the top five days or the top 10 days or the top 25 days in markets. And I think if you’re constantly as an end user trading and trying to get out in front of market moves, the likelihood that you make all of those days or invested on all of those days that have such a large impact in the compounding effective portfolios over time becomes quite slim.
So, if you can be convicted around an asset class and be convicted around a manager, I think staying invested is an incredibly important part of what you’re attempting to do, which is just to maximize or create triple net returns that are one tax efficient and help you grow into a much more comfortable position over time. So, again, back to why we think seeding liquidity is an appropriate part of people’s portfolios in that, if you don’t need the money, if you’re in a retirement account and again, you already have that tax efficiency and you don’t have that need for liquidity, you should get paid in every way possible you can for that.
Andy: I love that. To your point, so, I floated this idea on this program a couple of times, I’m gonna keep floating it, probably, I can’t help it. It’s my brainchild for private equity fund. And so, my thesis is this, illiquid, private equity, private credit alternatives, they have the potential to generate higher returns. You get paid that illiquidity premium, right? But even if they didn’t, let’s just pretend we’re in an alternate world where illiquid products, liquid products had the same return profile. You pointed out the behavioural mistakes, they happen over and over and over on the liquid side to 90% of investors, a huge portion of investors fall into behavioural traps.
So anyway, my product idea is, it’s private equity fund with a 10-year lockup, we charge, I don’t know, 5, 10 basis points. We take your money and we invest it in S&P and that’s it, and we offer you no liquidity. And we force you to stay illiquid. And it’s actually a value add by not even giving you the option for liquidity. We help you avoid behavioural traps. What do you think, is this a winning idea?
Colin: So, one of the things that I love about, at least the way that you can manage interval fund and the way that we approach it is that you can be a countercyclical buyer. And in our product, we strive to manage it unlevered in the majority of market environments. But because you’re not having to manage towards daily redemptions, nor are you facing any sort of pressure on the leverage side, when you get into environments where people start selling or people start making bad decisions or selling for non-fundamental reasons, they’re selling because they don’t wanna see negative returns or you know, they’re just too nervous to continue to hold on, you can start buying.
And you can do that either if you’re raising capital successfully, you can do that through inflows, you can rotate within your portfolio or you can borrow. And again, the leverage allowance within an interval funds is modest. But if you’re able to go out and buy an additional 25% of assets, for example, from people that are selling at, you know, “the worst time” to do so, you can really see an impact on returns through that countercyclical nature. And that’s what I think is so elegant about the way that the vehicle’s structured, and when managed properly gives you the ability to take your idea and kind of build on it and be buying from those that are selling it at times when markets are under stress.
Andy: So, we’re doing the opposite. We’re not just limiting our own behavioural mistakes, we’re leveraging the behavioural mistakes of others to enhance return. And sorry, other people, if you’re gonna panic at a blip in the market and sell for 95 cents on the dollar and we can buy at a discount, we’re gonna do it. So, it sounds like this fund is very actively managed. I guess, could you talk about the management approach and, you know, the investment selection within the fund?
Colin: Sure. So, for all of the products that we manage on the liquid side, we’re investment committee driven. We have an investment committee that consists of the senior portfolio managers across the firms, a combination of them. We each come from a different product specialty, whether that’s residential mortgage credit or commercial mortgage credit, or corporates, or CIO, for example. And what we attempt to do in investment committee is look at the macro environment and identify asset classes that have sustainable fundamentals.
And we’re big believers in giving ourselves a wide margin to be wrong. Meaning, that we don’t believe, we can’t appropriately predict pandemics or Russia’s invasion of Ukraine and its impact on the world overall. So, we don’t wanna have an investment thesis that rests on a razor’s edge of having to be correct or break one direction only for it to be successful. So, for us o over the past several years we’ve become increasingly more convicted and raise our allocation to it across the platform. US housing and specifically US mortgage credit has really exhibited that where you have a number of long-term sustainable fundamental trends that we think will result in housing being quite stable and mortgage credit performing very well on a fundamental basis looking forward several years.
And if we can identify those parts of the market that offer us outsize returns backed by those fundamentals, that tends to be where we deploy capital. If it’s on the daily liquid side, you know, we’re going to be more up the capital structure with a wider variety or larger diversification of assets into which we’re investing. If it’s in the interval fund, now we can invest at the point of the capital structure, whether that’s senior mezzanine or junior, that we think maximizes our return potential in light of that kind of bandwidth to be wrong, and that we seek and express a more concentrated view there. Because again, you know, we don’t have to manage towards the daily ins and outs that you see in a traditional mutual fund.
Andy: I mean, it almost sounds to me, it’s probably a bad analogy or comparison, but almost like a macro hedge fund or something where you trust the manager and you want to give them the freedom to sort of take advantage of inefficiencies, and you know, not total freedom. You know, as you point out there’s the regulatory framework to kind of constrain it somewhat, but then within that to sort of trust your investment committee. It sounds like you’re identifying big trends and then, you know, you’re creative and flexible enough that you can take advantage of the best opportunity rather than just, “We’re gonna buy this one tiny little asset segment over and over and over because we have to, because that’s our mandate.”
Colin: Yeah. And you know, what we tell investors and what we’ve demonstrated over our life as a firm is that we’re not going to stray, you know, from our core competency. You’re not going to wake up and find a big currency trade or a big emerging markets trade, however cheap, those may be a big municipal bond trade. Those markets can exist on their own. And we’re not anybody’s, we’re not 100% of anybody’s fixed income portfolio. So, we’re just a component within it, whether it’s fixed income or all portfolio. And so, we wanna be delivering, you know, a return off of a reliable set of assumptions from that investor.
And that’s that we’re gonna be in US structured credit and in corporate credit, but we’re going to stay domestic and we’re gonna stay focused on our core competency and not go too far afield. So, it’s not a true unconstrained fund in that regard, but we are going to move within our sandbox, and you know, identify the best opportunities within it.
Andy: Yeah. Honestly, zooming out, that’s where I think a lot of the best thinking happens, is within constraints, right? It’s like maybe, I don’t know, it’s not a paradox exactly, but you’re talking about, you stay in your core competency, you stay in that mandate, but then you have some freedom within that. And I mean, honestly, I think that’s where a lot of professionals, a lot of creative thinkers do their best work, is not totally unconstrained, but given the set of constraints, where’s the value right now? And I think it’s interesting that this product and this strategy is in an interval fund wrapper because it seems like this kind of a strategy, this asset class could be in several different wrapper types, right? So, you know, why the interval fund? Why the intermittent liquidity? What is it about this product structure that really, you know, is optimized for the strategy within the fund?
Colin: Well, as I mentioned, when I was walking through US structure credits to begin with, is that structure credit is what it sounds like, it is structure. There are a number of what are called tranches or bonds that are issued off of each of the collateral pools. And those tranches have different sizes, different ratings, different seniority versus one another. And clearly, typically, the further up the capital structure you are or the higher quality credit you’re in, those tranches are larger, broader sponsor or liquid. But you may, from our perspective, you may not see losses occurring anywhere in the investment grade portion of the capital structure, and you may have to go all the way down near the bottom of the capital structure to identify securities towards the equity or single B, where you start to see losses tick up in a bear case scenario.
And so, in a daily liquid strategy, you see a lot of structured credit. We match a lot of structured credit in daily liquid, but it tends to have a more senior part of the capital structure skew to it. Whereas in the interval fund, we can focus on those securities where again, we’re seeking to kind of maximize the returns that we can generate. So, you know, perhaps it’s being a bond above where we see losses in a bear case outcome. And that may be further down the capital structure than we’d be comfortable doing in concentrated formats, in a daily liquid vehicle.
Andy: Got it. So, with this interval fund, it’s obviously it’s intermittent liquidity, right? It’s not totally illiquid, it’s not totally liquid. How does it work from a practical standpoint? Is it a monthly liquidity option? Is it quarterly?
Colin: Sure. So, we price daily, and it comes out every day. It is available for purchase daily. Redemptions are done quarterly. The SEC minimum is a 5% fund-level gate. So, 5% of assets must be able to be redeemed at any given quarter. That’s actually voted on by the fund’s board of directors. So that can be 5, it can be 10. And you can see that number kind of accordion up as investor demand may, and as market conditions would allow. Typically, you may have an environment where, you know, you’re always trying to do what’s the best for fund investors where the market is distressed, and you are generating…
I think one of the unique things about structured credit is that you’re generating quite a bit of cash flow on a monthly basis through return of principal from the securities that you hold. So oftentimes, we can generate organically without having to sell a single security, ample cash flow to pay…
Andy: Well, is there like an overall blended yield? You know, is that published? So, I’m also just throwing off income left and right, but I guess the yield is going… Does that just get paid directly to the investors or how does the yield play into this redemption?
Colin: The yield gets paid as a dividend, just as you would see in an open-ended or closed-end mutual fund.
Andy: Got it. Got it. And then as far as the leverage goes, it sounds like that’s fairly tightly regulated, but you have the options. You don’t have to use the leverage, but you can. Can that be used for redemptions at all?
Colin: It could, you could lever up to pay out redemptions, you could borrow to do that. That’s, you know, philosophically something that, it just depends on the market opportunity set that is available at the time. Clearly, you know, if the fund is shrinking, levering into it would increase the overall leverage of the strategy. Now, it may be an environment where you would rather rebuy your portfolio if you didn’t have adequate cash to meet those redemptions and as a result, you would choose to lever to meet them. To date, we’ve not made that decision within our strategy, but it is something that you could absolutely do.
Andy: Well, I think it’s good though. I think with interval funds, it’s good when there’s a little bit of flexibility on the other side where, you know, not total freedom, not totally free of constraints, but you have a little bit of room to, you know, react to market conditions and pressure valve releases or whatever you want to call it. So, I think we have a pretty good feel for the product, and thank you for walking us through that because I think a lot of investors maybe haven’t invested in interval funds. And you know, obviously, they’re gaining traction for a reason, right? Between this world of liquid investments and totally illiquid, private equity, you know, 5, 7, 10-year hold stuff, they’re a popular wrapper for a reason. They’re gaining traction for a reason.
But I wanna zoom out, talk a little bit more about the macro picture before we run out of time. So, you mentioned, you know, that your team, you anticipate, obviously, we’re seeing some disinflation and you even said that we may touch too briefly, but then, you know, that might reverse, we’re not gonna stay at 2% inflation, so there may be higher sustained inflation going forward. We’re also coming off a pretty bad year for stocks and bonds last year, right? Do you see that reversing for this year? Do you see this year overall being bullish for fixed income and for credit?
Colin: I do. I think just the natural calming down of volatility. I mean, as we started to move off of the zero bound, you know, the aggressive nature by which the Fed moved to tackle inflation, just put, I think a tremendous amount of uncertainty in volatility into the market. And just the calming down of that alone, as we reach, you know, near peak policy here in the first part of the year, I think it’s very constructive for asset returns, both fixed income and equity in the short term.
Andy: And what about, you know, the recession? Because honestly, the whole last three years, they’ve been so odd. They really have. And there are so many negative things going on in the economy, but at the same time, I feel like there’s a group of investors, professionals, maybe even myself among them at times, it’s almost like we’re rooting for a recession, and then it sort of feels like maybe it’s not gonna come. This may be a kind of a muddle-through, I hate to use the phrase, soft landing, that may be what this is.
Don’t get me wrong, I don’t know that the Fed knows what they’re doing. I don’t know that policymakers… I see mistakes being made left and right, supply chains, all of it. Believe me, I can list 100 mistakes, but nevertheless, it kind of seems like things are recovering and we might muddle-through. So, do you think we’re in a recession? Are we facing one? Or is there a chance that we’re gonna kind of squeeze by somehow?
Colin: Yeah. From an investment committee perspective, our base case remains that we will get a recession towards the end of this year. You know, how much of that feels like one versus how much of it is more data-driven, I think is still to be determined. I don’t envy those in a policy seat having to, you know, from a Central Bank perspective, having to navigate through this environment I do think that we will get, you know, numbers that flash recession, we think it will give, you know, Chairman Powell and the FOMC the opportunity to pause, potentially enabling inflation to start to stick back up. I don’t think we’re heading towards particularly deep recession one way or the other.
To your point, this would have to go down as the most, you know, projected and perhaps, you know, televised recession of all time as we’re heading into it. So, I think there’s a lot of uncertainty around what’s going to happen. Typically, if everybody’s thinking one thing, it’s not a bad idea to take the other side of it. But everything you look at from a data perspective seems to point to us rolling into one at the end of this year.
Andy: And your investment committee and you know, how you’re predicting that, are we still using the technical definition from like three years ago when a recession was defined as two consecutive quarters of negative GDP growth?
Colin: Now, back to the comment round, will it be data-driven? Will we actually feel it? I think we do have to use the technical definition, at least as we’re talking about it, whether that leads to, you know, again, some of the same pain and suffering people have experienced in prior ones, will see, but yes.
Andy: Yeah. I’m sorry, but folks, we need technical definitions. If economics is supposed to be some sort of science, you know, if this is supposed to be data-driven, we need to have common definitions, and I’ll get off my soapbox in a second. But then those also have to, you know, decade from decade, we need to have this consistent definition of recession. So, I’m with you. Let’s stick with that definition, and to your point though, that not every recession is gonna look or feel the same, right? And so, you know, folks can be feeling economic pain, but not technically in a recession, or the economy could technically be in a recession, but the labor market could be very strong, right? These things, they don’t always look and behave exactly like the last one, right?
Colin: Right. I think everybody, you know, is guilty of fighting the last war as it were. And you know, I think you’ve seen that in a lot of the narrative around housing. I mean, every day I open up, you know, whether it’s “The Wall Street Journal” or “Bloomberg” or other publications to a negative headline on housing. You know, as we dig in, I don’t think it computes with what’s really going on in US housing. But I think each one will be unique. This will not be like the last one. I think we can all be certain of that, but that’s probably about the only thing we can be certain.
Andy: I think we gotta end on that one, Colin, it’s not gonna be like the last one. I think I gotta give my stamp of approval on that statement. And that being said, thank you so much for coming on the show, talking about structured credit, your funds, your offerings, just the macro picture, really insightful stuff. Where can our audience of high-net-worth investors and advisors go to learn more about Angel Oak Capital Advisors and your investment offerings?
Colin: Sure. Angeloakcapital.com is a great place to start for all of that.
Andy: Absolutely. And I’m gonna link not only to the website and Colin and Angel Oak’s LinkedIn page, but I also wanna link to the credit fund and the research, because I want our listeners to be able to access some of this research because it’s really good, and I just like the framing of it. It really kind of pulled me in, you know, to the story. I think sometimes writing this kind of content or research, you have to put it into a story to make it digestible for a guy like me to really pull me in. And you guys did really good job on that. So those show notes are always available at altsdb.com/podcast, and they’ll be published as soon as you’re listening to this. Colin, thanks again for joining the show today.
Colin: Thanks so much, Andy.
