A Conversation with Cheryl Pate, Angel Oak Capital Advisors

Angel Oak Capital Advisors is a financial services firm with income funds that primarily deal in bank debt.

Today’s DailyAlts interview is with Portfolio Manager Cheryl Pate.

One of them is an open-ended mutual fund.

The Angel Oak Financials Income Fund. Ticker, A-N-F-L-X.

The company also launched a closed-end fund focused largely on the same opportunity in May 2019.

The ticker for this fund is F-I-N-S.

The closed-end fund capitalizes on some of the less-liquid opportunities in community bank debt.

The open-end fund has been around almost five years now. It is five-star rated, and roughly 70% of the assets center on community bank debt. The firm currently foresees more opportunistic investments in non-bank financials. It also has a small sleeve of community bank equities too.

Tim Melvin: Can you tell me about the opportunities you see in banking debt? 

Cheryl Pate: Predominantly, we invest in “subordinated debt.” It’s a capital tool that banks have used for a number of years. However, it really only made its way down to the community bank space – which we define as banks with $30 billion in assets or below – in the post-crisis period. In 2014, we saw this market opportunity emerge. It’s a tool for capital for banks that would qualify as Tier 2 regulatory capital. For the banks, it’s structured as a “10-year, no call five,” and the capital treatment starts to phase out those last five years. We’ve seen the opportunity as a fairly niche market in the smaller bank space, with smaller deal sizes. It’s a market that has roughly $20 billion in debt outstanding and annual issuance tends to be $3 billion to $5 billion per year.

It is very much, dependent on strong relationships with broker-dealers that bring these types of transactions to the market.

The other opportunity is to drive excess yield relative to other investment-grade corporate credit.

We think the capital added to the sector, the changes in underwriting, and the increased regulatory oversight has really made them, we would say, one of the more attractive areas of corporate credit. When we look at where leverage has gone in corporate credit broadly versus the banking sector, bank credit which has increased their capital base by a third seems better positioned than the broader market.

Melvin: What kind of coupon are we seeing on newer deals we’re seeing?

Pate: It is correlated to the size and if there’s a public rating on the deal. The larger end of the spectrum, we’ve seen some deals come to market in call it $20 to $30 billion size range that is probably 4% to 5% coupon.

It tends to be fixed for the first five years, floating thereafter. We see opportunity in that $10 billion and below space where you’ll see a mix. If the deal is rated, and it’s towards the larger end of 5% to 6%, north of 6% for a smaller non-rated transaction, and that’s a key opportunity. That’s really what the closed-end fund is able to take advantage of given the liquidity profile of a closed-end fund.

We don’t think these are non-rated because they’re not investment grade. Really, they’re not rated, because it’s a small $500 million bank that is going to do a $10 million issuance. That doesn’t make economic sense to go out and engage one of the credit rating agencies. We do that diligence ourselves; we have a proprietary model that screens all the banks, similar to what the rating agencies do from a quantitative perspective. That’s our first look, and everything has to pass the investment-grade test before we continue diligence.  I should say we’ve invested about $1.5 billion in this strategy over the last five years, over 165 banks. The credit rating that our proprietary model [provides] for the non-rated space actually tends to be a little bit higher than the rated public banks.

Melvin: With all the capital in the banking space, the default rate has to be close to

zero, correct?

Pate: Yes. I track the issuance in the space. There’s roughly $20 billion in notional [for] about 320 deals over the last five years. There’s only one that defaulted, and it was really a unique situation.

Melvin: You’re capturing almost higher-level junk bond yields with what’s basically non-junk qualities, is that an accurate description?

Pate: Yes. We say that all the time. High-yield type returns for investment-grade risk. But actually, where the average BB comes out today, we’re definitely seeing yields in excess of that.

Melvin: That has to be an attractive opportunity in a world where lower interest rates for longer is definite, and lower forever is possible.

Pate: Right, absolutely.

Melvin: Now, do you use any leverage in the closed-end fund?

Pate: In the closed-end fund, we are able to utilize leverage. It is a 40-Act Fund so it abides by 40 Act rules which depending on how you define leverage, it’s 33%. We’re not anywhere close to that. We really have only started employing some leverage in the last couple of weeks. And we don’t expect that we’d be anywhere near that 33% regulatory limit.

Melvin: You’re using a managed distribution rate policy, is that correct?

Pate: Correct.

Melvin: So right now, it’s about a 7% yield, is what I’m looking at here?

Pate: That’s right.

Melvin: Why aren’t people lined up out the door begging to buy this?

Pate: I think we had a tremendously successful marketing period for the IPO. It came out at the end of May, it was successful beyond our expectations, and we are getting some people that participated in the deal come back and say, “Are there follow-ups coming? We’d like to get bigger positions.” So, it’s been very well received.

Melvin: There’s almost no discount to the shares at all right now. Is that good thing for you?

Pate: Yes.

Melvin: Let’s talk in broader terms about the bank mergers and acquisitions (M&A) outlook, I know the number of deals has slowed this year, but the average size seems to have gone up. Am I on the right track there?

Pate: That’s what we’ve seen this year. It’s been moving up the size spectrum, from really what was mostly in large community banks and regional banks, up towards that upper end of the regional banks. I think the regulatory backdrop for larger deals has become more friendly. Second, you have a sector in search of efficiencies and meaningful cost savings in the face of what I would characterize by the tougher earnings and rate environment. We’ve started to see some of these bigger banks come out with mergers of equals, which we think is a trend that does likely continue. More modest premiums on a MOE type transaction lessens the execution risk, all else equal. I would say we do typically see a seasonally more active second half in the year. We look for M&A to accelerate from current levels through 2020 as banks try to generate more operating leverage in their business model when net interest margins are likely to compress.

Melvin: The compression of net interest margins, will those pains be felt more at the smaller bank level?

Pate: It really depends on the business mix. When you look at community banks, they are much more deposit funded than the larger counterparties. And the cost of funds is obviously still very low across the sector. It’s generally less than 1% given a higher proportion of deposit-based funding, and obviously the cream of the crop there being non-interest-bearing checking and savings accounts. There’s not a lot of room to bring deposit costs down, and net-interest margins tend to be higher for community banks than the bigger banks. The degree of compression, depending on loan mix, is really going to be a key determinant. The other thing to highlight is that when you’re looking at a community bank, loan portfolios tend to be highly skewed to commercial real estate and commercial & industrial loans.

Melvin: Is there any regional difference in the M&A market? I know sometimes the Southwest is the most active and at other times, it’s the mid-Atlantic. Where do you see activity developing?

Pate: If we take a step back and look at 2018, it was very much concentrated on the eastern half of the country. The West Coast has been somewhat quiet. The Southeast continues to be very active, Atlanta in particular. We’ve seen a lot of activity in our backyard. I think it comes down to higher growth footprints, number one, being attractive to “potential acquirers.” The other piece is that there is a lot of over-banked markets out there. We may potentially see some more activity in these areas. Chicago area stands out as one of the more over-banked markets. I wouldn’t be surprised to see more consolidation.

Melvin: Any other thoughts on what’s going on in the banking industry?

Pate: We have the opportunity to look across the capital stack in banks in particular.

We have a preference for bank debt at this part of the cycle when we think about the drivers of performance and sitting higher up the capital stack in a sector that really has significantly more capital, but not only that, credit or asset quality is the key driver that we’re watching in terms of any potential warning signs, cracks of things to come. And really the credit trends that we see remain very solid. I think everybody has been expecting credit costs to somewhat normalize over the last couple of years, and I feel like we sound like a broken record, because we’re still waiting for that. And even second-quarter earnings we saw industry-wide, non-performing asset ratio down and net charge offs flat. And so, I don’t think we’ve seen any signs of increasing delinquency or credit issues. Systemically, there were some pockets of commercial credit that we’re keeping our eye on and there were some I would call isolated events, a lot of which seem somewhat fraud-driven, but that’s what we’re really watching but we’ve not seen the signs of it yet.