SEC Form N-CSR filed by Angel Oak Financial Strategies Income Term Trust

 

 

 

 

 

 

Peachtree Rd. NE, Suite 1725

 

 

 

 

 

 

 

 

January 31, 2024

 

 

 

 

Angel Oak Capital Advisors, LLC

3344 Peachtree Road NE

Suite 1725

Atlanta, GA 30326

(404)

 

For the period ended January 31, 2024, the Angel Oak Financial Strategies Income Term Trust (the Fund) returned 1.09% based on market price and 2.37% based on net asset value. During the same period, the Fund’s benchmark, the Bloomberg U.S. Aggregate Bond Index, returned 2.10%.

The financial sector accounts for substantially all of the Fund’s assets. There are three areas of primary focus in the financial sector: community bank debt, nonbank financials debt, and financial sector equity (preferred and common). The Fund’s financial sector asset allocation comprises approximately 66% of assets in community bank debt, approximately 28% of assets in nonbank financials debt, and approximately 5% of assets in preferred and common equities of banks and nonbank financials. In addition, approximately 1% of Fund assets are in cash and other assets.

The regional bank failures in the spring of 2023 highlighted concerns relating to the rapid rise of interest rates and the resulting impact on bank investment portfolios and accumulated other comprehensive income (AOCI). While the bank failures were more idiosyncratic than systemic, given their unique business models, bank debt and equity markets remained dislocated. Over the second half of 2023, contagion risk has faded as bank earnings proved resilient and stricter regulation is anticipated. Additionally, as rates rallied around the end of 2023, AOCI and capital levels improved, as did equity valuations, to some degree. Bank debt tends to lag equity performance, and we believe bank debt is well-positioned to outperform the broader fixed income market in 2024.

The bank failures and ensuing market volatility beginning in March 2023 were largely driven by liquidity concerns in conjunction with the rapid rise in interest rates. This was particularly evident in the unique business models of the failed regional banks, given their highly concentrated deposit bases and high level of uninsured deposits. Banks typically lag interest rate increases and similarly were slow to adjust deposit rates to the steep increase in interest rates this cycle. When weakness surfaced in the banking sector, depositors withdrew their funds at an unprecedented pace, and banks were forced to sell bonds out of their investment portfolios, realizing losses and, as a result, eroding their capital bases. As part of their response, regulators created a new Bank Term Funding Program (BTFP) at the discount window, allowing banks to borrow the par value of a wider range of securities so banks could avoid selling bonds and realizing losses for securities. The BTFP was successful as part of the solution to quickly stabilize the banking system. Since then, we believe banks have worked hard to strengthen their deposit bases. Banks adjusted deposit rates higher, to levels more commensurate with market rates (pressuring net interest margins) and employed creative solutions to enhance the amount of deposit insurance available to their depositors. Additionally, over the course of 2023, the level of uninsured bank deposits improved meaningfully.

From a fundamental perspective, while 2024 will likely bring with it a still-tough operating environment for banks, we believe net interest margins (NIM) pressures are abating, valuations are cheap, and mergers and acquisitions (M&A) activity should accelerate. We believe navigating the rate and credit environment and managing expenses will be top of mind for bank management teams.

We believe NIM pressures should gradually fade with the Federal Reserve (the Fed) on pause. Additionally, we believe margins will continue to compress on higher funding costs in the near term, but at a decelerating pace, before stabilizing and shifting to expansion in the second half of 2024. Historically, deposit costs have continued to rise until the Fed begins cutting rates. We believe loan and securities repricing will provide an offset to higher funding costs.

Given the rapid rise in interest rates over the past several quarters and the ensuing pressure on consumer and corporate debt servicing capacity, we believe credit will continue to normalize from the levels as of the period end. Consumer credit cycles play out faster than commercial credit cycles, and delinquencies have been increasing for both credit card and auto portfolios. We believe early signs from securitization trusts point to deceleration in the pace of delinquencies, and risk-adjusted margins remain positive.

We believe CRE, particularly office CRE, is a larger headwind; however, it is important to understand banks’ exposure to the CRE market. More than half of CRE resides outside the banking system, and banks tend to be more conservative underwriters in terms of cap rates and ratios. With few exceptions, bank exposure to office CRE

 

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tends to be less than 5% of total loans. Over the course of 2023, banks enhanced their disclosure on CRE portfolios and built up loan loss reserves. While we believe this CRE cycle will likely be more severe than prior cycles, given the shift to increased work-from-home and hybrid work arrangements and that there remains headline risk, overall, we believe the banking sector is well-reserved and well-equipped to manage through deterioration in its CRE portfolios, particularly as CRE credit cycles tend to play out over multiple years.

The banking sector is also grappling with elevated expenses, particularly related to increasing regulation and higher deposit costs. While the biggest changes from a tougher regulatory regime are expected for regional banks with assets between $100 billion and $250 billion, we believe all banks will need to operate under a stricter regime. Incremental costs relating to compliance, risk management, etc., will pressure bank expenses. Additionally, compensation costs account for the bulk of bank expenses, and we believe technology remains a necessary investment from both cybersecurity and competitive perspectives. We believe M&A activity should reaccelerate in 2024 as banks focus on improving scale and profitability. We believe cost savings from bank consolidation are tangible and meaningful—they typically range from 20% to 30% of the acquired bank’s expenses.

In terms of Fund positioning, we believe the opportunity set is attractive across the banking spectrum. Despite the recovery in bank equities in the fourth quarter of 2023, we believe valuations remain muted. Additionally, spreads on bank debt remain at wides, with little of the benefit from lower rates reflected in prices.

We believe there is a fundamental mispricing of bank debt in the current market. The most typical instrument issued, subordinated debt (sub debt), is a Tier 2 regulatory capital instrument that is structured with a final maturity, with the bond becoming callable and switching from fixed rate to floating rate at year five. The key rationale for issuance is the regulatory capital treatment. Once there are less than five years to maturity, capital eligibility declines ratably over the last five years (i.e., 80% in year six, 60% in year seven, etc.). The market is pricing these bonds assuming they will be outstanding until maturity. We believe this is fundamentally incorrect. While banks are unlikely to issue below current yields, banks issue these bonds for capital purposes rather than funding purposes. Banks can fund themselves much more efficiently through alternative sources, mainly deposits. Thus, the key consideration for calling a bond and issuing new sub debt hinges on the effective cost of capital. While a case can be made for keeping these bonds outstanding for a year or two following the initial call, the debt becomes expensive funding past that point.

We are optimistic that the primary issue market will reemerge with strength in 2024 for several reasons. First, $1.8 billion of community bank debt is maturing, and we fully expect most of these banks will have to refinance those notes as they come due. Secondly, there is an additional $2 billion of debt outstanding that is already in the floating-rate period. These bonds have had their coupons reset higher and are losing regulatory capital eligibility at 20% per year, rendering the debt expensive and inefficient. Finally, approximately $4 billion of debt will enter the call/floating-rate period this year. We believe a robust primary market should also guide the secondary market, driving attractive investment opportunities across the community bank debt landscape.

We believe bank equities are cheap by any measure, as a lack of conviction about the pace of rate cuts and the depth of credit normalization has been keeping investors on the sidelines. As more clarity emerges in the first half of 2024, bank equities could offer investors a compelling upside. We favor community banks with strong deposit franchises, attractive footprints, and expectations of being beneficiaries of an upcoming M&A cycle.

Across the financial services landscape more broadly, we see select opportunities for investment-grade insurance, asset management and other financial services senior debt, and residential mortgage real estate investment trust common and preferred equities. We do not anticipate the Fund’s subsector allocations in financial services will change materially in 2024.

A general ledger account listed in the equity section of a company’s balance sheet.

An unmanaged index that measures the performance of the investment-grade universe of bonds issued in the United States. The index includes institutionally traded U.S. Treasury, government-sponsored, mortgage and corporate securities. It is not possible to invest directly in an index.

 

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Subordinated debentures of financial institutions with total assets of less than $20 billion.

A floating-rate security is an investment with interest payments that float or adjust periodically based upon a predetermined benchmark.

NIM is an industry-specific profitability ratio for banks and other financial institutions. It is a measure of the spread a bank earns between interest income and the amount of interest paid out to its depositors, expressed as a percentage of earning assets.

The difference in yield between two bonds of similar maturity but different credit quality.

A bank’s supplementary capital including evaluation reserve, undisclosed reserves, hybrid security, and subordinate debt.

 

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The investment objective of Angel Oak Financial Strategies Income Term Trust is to seek current income with a secondary objective of total return.

 

 

 

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LIBOR: London Inter-Bank Offered Rate

SOFR: Secured Overnight Financing Rate

SOFRINDX: Secured Overnight Financing Rate Compounded Index

TSFRM: Term Secured Overnight Financing Rate

H15T5Y: 5 Year Treasury Note Constant Maturity Rate