If you are an investor whose main objective is income, the current low-interest-rate environment may have pushed you toward stocks with high dividend yields.
But some income-seeking investors still want to avoid the risk and volatility of the stock market. There are plenty of bonds funds out there, but if you would like one that provides monthly income, lower volatility and the prospect of some capital gains, the Angel Oak Financials Income Fund may work to your advantage.
Johannes Palsson, one of the fund’s managers, described its industry niche in an interview for this article.
Banking industry consolidation
As its name implies, the Angel Oak Financials Income Fund is focused on the banking industry. More specifically, the fund buys subordinated debt of community banks. This debt is included in banks’ regulatory capital (specifically, Tier 2 capital) and an increasing number of small to medium-sized community banks have been issuing this form of debt in recent years.
Following the 2008 credit crisis, banks were required to increase their capital under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. According to Palsson, U.S. banks have about 30% more regulatory capital (relative to assets) than they did before the crisis. But banks were also required to improve the quality of their regulatory capital, with new limitations on the amount of deferred tax assets, mortgage-servicing rights and other types of “intangible” capital that could be included.
Palsson said the U.S. banking industry is “as healthy as it has ever been,” because of the increased capital, strong loan quality and a more robust regulatory regime than we had before the 2008 financial crisis.
Larger banks had been issuing subordinated debt for a long time, Palsson said, but now it has become much easier for smaller community banks to access the capital markets and issue their own subordinated debt securities.
“In 2014, it started to take off,” he said.
The Angel Oak Financials Fund was established in November 2014. Palsson stressed that subordinated notes purchased by the fund are traded on exchanges, which means they are much more liquid than notes that are privately traded. The subordinated notes typically have 10-year terms, with interest rates fixed for the first five years and floating for the last five years. The floating feature reduces price volatility. The effective duration (modified for call dates and options) for the fund was 3.2 years and its effective maturity was 4.6 years as of Sept. 30.
For many reasons, including economies of scale, ever more onerous regulatory reporting requirements and the higher capital levels that reduce returns on equity, the U.S. banking industry is continuing to consolidate rapidly. There were 5,303 banks as of June 30, down 4% from 5,542 a year earlier and down 20% from 6,656 as of June 30, 2014, according to the Federal Deposit Insurance Corp.’s Quarterly Banking Profile reports.
The Angel Oak team expects industry consolidation to continue at an annual pace of 5.5% to 6%. “Quite frankly I think the regulators would like to have fewer banks in the country,” Palsson said.
Johannes Palsson, portfolio manager of the Angel Oak Financials Income Fund.
And this is where the special opportunity lies for the Angel Oak Financials Fund. When a community bank that has issued subordinated notes is acquired by a larger bank, the acquiring institution guarantees the smaller bank’s subordinated debt. The acquirer’s subordinated notes typically have higher credit ratings (and therefore lower yields) than the smaller bank’s notes. This means the acquired bank’s notes will immediately rise in value when the merger is completed.
The higher values for the acquired bank’s subordinated debt can increase the return for the fund’s shareholders.
Palsson provided three examples of this type of M&A deal that the fund has or may benefit from:
• TIAA acquired EverBank Financial Corp. of Jacksonville, Fla., in June 2017. The fund was holding subordinated notes issued by EverBank with a coupon (the yield based on the amount of debt the bank issued) of 6%. The notes were rated BBB by Kroll Bond Rating Agency. But TIAA was rated AA by Fitch Ratings, with its own similar debt yielding 4.125%. “So we saw roughly eight or nine percentage points of immediate price appreciation in the EverBank paper when the merger took place,” Palsson said.
• Sandy Spring Bancorp of Olney, Md., announced a deal in September to acquire Revere Bank of Rockville, Md. The acquiring bank has about $8.4 billion in total assets, while Revere has $2 billion. “This bond is a little closer to its call date so the gains will not be as great as in the EverBank example, but still a very nice gain,” Palsson said.
• People’s United Financial PBCT, -0.61% of Bridgeport, Conn., completed its acquisition of United Financial Bancorp of Hartford, Conn. The deal had been announced in July. “We ended up liquidating our position [in notes issued by United Financial Bancorp] significantly above our mark at the time of the announcement,” Palsson said.
The fund also holds securities issued by other banks that have been involved in recent M&A activity, including RBB Bancorp RBB, -0.35% of Los Angeles, Cadence Bancorporation CADE, +1.19% of Houston and Ameris Bancorp ABCB, -1.06% of Moultrie, Ga., Palsson said.
The fund is broadly diversified, holding 115 securities as of Sept. 30. Top holdings include bonds issued by:
• Wachovia, which was acquired by Wells Fargo WFC, +0.04% in 2008.
• Cullen/Frost Bankers CFR, -0.57% of San Antonio.
• Eagle Bancorp Montana EBMT, +1.58%.
• Arrow Financial AROW, -0.03% of Glens Falls, N.Y.
• German American Bancorp GABC, -0.45% of Jasper, Ind.
Share classes and yields
The Angel Oak Financials Income Fund has several share classes, all of which are rated five stars (the highest rating) by Morningstar, within the research firm’s U.S. short-term bond fund category. These two classes have the highest yields:
• The institutional shares ANFIX, +0.00% are available through financial advisers, had a distribution yield of 4.44% as of Sept. 30 (based on the most recent monthly distribution divided by the closing net asset value [an open-ended mutual fund’s share price] on that day. The SEC 30-day yield (the actual current yield for this share class of the fund) was 4.17% as of the close on Nov. 18, according to Morningstar. This share class’s gross annual expenses are 1.18% of assets. However, net expenses are 0.69% until at least May 31, 2020, because Angel Oak Capital Advisors has agreed to waive its advisory fee until that date.
• The Class A shares ANFLX, +0.00% have a sales charge of 2.25% that is waived through most online brokerage platforms, including Charles Schwab, Fidelity, E-Trade and TD Ameritrade. This share class had a distribution yield of 4.19% as of Sept. 30 and a 30-day yield of 3.83% as of Nov. 18, according to Morningstar. The gross expense ratio is 1.43%, but the net expense ratio is 0.94% until at least May 31, 2020, because of Angel Oak’s advisory fee waiver.
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