Housing Recovery Will Boost Mortgage Bonds

NEW YORK ( TheStreet) -- The housing market recovery is for real and that's creating significant opportunities in the residential mortgage-backed securities, or RMBS, market, says Brad Friedlander, portfolio manager for the Angel Oak Multi-Strategy Income Fund ( ANGLX).

The $456 million fund, which was launched in June 2011, has returned 21% in the past year, according to fund tracker Morningstar.

Welcome to TheStreet's Fund Manager Five Spot, where top fund managers give their best stock picks and views on the market in a five-question format.

What is your view of the economy?

Friedlander: Our view is that the macro U.S. economy will muddle along, producing mediocre growth over the next few years. In the face of a modestly improving economy, there are a few bright spots. I believe the labor market should continue to improve, leading to lower unemployment over time.

The housing market is another area that may outperform as home prices have rationalized, possibly even overshooting to the downside. While many homeowners are still delinquent on their mortgages, we believe the housing market may surprise to the upside, as a clear beneficiary of recent Fed policy. In turn, a healthier housing market should manifest itself in additional consumer confidence.

Based on that outlook, how are you structuring your portfolio?

Friedlander: An overarching theme over the next few years is our focus on credit-based strategies. I continue to be excited about the value in non-agency mortgage bonds. Within non-agency RMBS, we have decided to focus on a higher quality subset of the mortgage market and by that I mean seasoned bonds with 7-10 year payment histories and borrowers that are "above water." Or, in other words, borrowers that have the freedom to refinance, move, and pay down their mortgages.

In addition, I believe the market is baking in loss assumptions that are still too harsh. As the housing and labor markets improve over the next year and finding acceptable yield becomes ever more difficult, I believe spreads across this asset class should tighten, providing potential for price appreciation.

Do you see a "sleeper" or "under the radar" sector of the fixed income market? If so, would you mind telling us what it is?

Friedlander: I believe the floating rate sub-sector of the non-agency mortgage bond market is significantly undervalued. This portion of the asset class underperformed as long-term interest rates declined dramatically since early 2011, driving investors to be "coupon hogs." These floaters have multiple benefits including low interest rate risk and increasing income in a rising rate environment. Additionally, these assets are still trading at a large discount to par and are essentially called back at par via refinancing and other pay downs.

What areas of the market are you presently avoiding?

Friedlander: Currently, we are underweight agency mortgage-backed securities. Sure, the Fed is providing significant technical support, committing to large-scale purchases indefinitely. While this action is positive for the asset class over the near term, once the Fed shifts policy, this temporary support will be gone, lowering overall demand. The problem with Agency MBS arises from increased pay downs, such as refinancing. Since the asset class is trading at a premium, an increase in pay downs lowers investors' realized returns.

Finally, what is your outlook for 2013?

Friedlander: We think that the housing market will continue to improve, pulling the economy along with it. Fed policy will push investors towards non-government guaranteed assets as they search for yield. As money managers begin to look at less traditional fixed income products, we expect to see spreads tighten across the board. However, it is important that we continue to see improving fundamentals driving spreads tighter, not just managers seeking yield, as such is the case in housing. Non-agency bonds offer investors the opportunity to capitalize on these events while taking minimal interest rate risk.

-- Written by Gregg Greenberg in New York.
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