American Capital Mortgage Investment: Was The Baby Thrown Out With The Bathwater?

| About: MTGE Investment (MTGE)

Stocks fell soon after Bernanke's taper comments about 10 weeks ago, and whether REITs like ARMOUR Residential (NYSE:ARR) and American Realty Capital Properties (ARCP), or dividend payers in other sectors like AT&T (NYSE:T), they were sold heavily until the Fed reassured the markets that tapering did not equal tightening.

Whether you think the move is justified -- because of their sensitivity to interest rate moves -- or not, some solid companies were "thrown out" with the weak ones during that selling. American Capital Mortgage Investment Corp. (NASDAQ:MTGE) is one such company.

The Premise for Selling REITs

There tends to be an inverse relationship between REITs and interest rates for a few reasons.

First, because REITs pay out so much of their profits to their shareholders, their demand for them benefits from an absence of yield in other assets that are tied to interest rates, like treasuries, savings accounts, and CDs. Investors crowd into these high dividend paying stocks, like REITS, and their share price benefits.

Below is a chart that shows the correlation, between REITs and 10-year Treasuries. Since 1990, the relationship is more apparently inverse.

via Investopedia
(Click to enlarge)

In addition to the demand by investors searching for yield, traditional REITs generally keep a large amount of their equity in property debt and need financing to fund further property purchases. If rates are rising, it means that their interest payments rise and their investments generate lower profits for them, meaning lower payouts to you.

Finally, there are other economic scenarios that affect different types of REITs more than others. For instance, REITs that deal primarily with multi-family housing could benefit from increases in rates since people would be less likely to take out a home loan and prefer to rent. Multi-family REITS are also more likely to have short-term leases, unlike commercial REITs, and if the economy improves it will give them greater pricing power to capture prices on economic growth.

So do these correlations affect every REIT, and if so, how will it apply to MTGE? The short answer is that it does not affect every REIT equally, though it will affect REITs in one way or another.

MTGE is a hybrid mortgage REIT, which means that it does not actually really manage properties. It is involved in arbitrage between short-term interest rates and mortgage-backed securities. By doing this, it is more flexible than a traditional REIT, tweaking their investments to suit the economic climate.

It owns agency and non-agency MBS. More than 90% of its portfolio is in agency MBS. Agency MBS seem to have priced in the taper, as their spreads are back to pre-QE3 levels, so they may not see much more downside and MTGE may have seen the worst of it too.

The CEO noted the spread contraction on agency MBS in the earnings call:

Of the prior year, we have clearly seen a compression of the credit curve in these assets, with yields on cleaner paper now within 100 basis points of lower credit paper. This was closer to 300 basis points in Q1 2012.

I believe that this type of hybrid REIT has seen the worst of it this year. Now that tapering is in sight, they can adjust their maturities and hedging. And if tapering is priced into the spreads, there should be less change there too.

It is worth noting that some major investors have not been dissuaded by the recent sell-off or the projected earnings decline, perhaps because they also noted the reversion to pre-QE3 levels, and think that there is limited further downside. Pine River Capital Management upped its stake to over 9% since a reported smaller stake back in April. They obviously see value in the company at these levels. Additionally, in May after the stock had started selling off, the CEO of MTGE purchased over $300k in company shares.

Financial Condition

MTGE looks financially strong. The company pays almost a 17% dividend, which is high even for a REIT. They sport a forward P/E of 6.47 and have a price to book ratio of only .63. I believe this is mainly because people fear what tapering will do to their business and the value of their shares. But this may still constitute undervaluation.

The company has over $6.50 in cash per share, with no debt, which means that dividends can be sustained. Also, as noted below, they have hedges in place to mitigate negative effects of rate increases, so that should limit the possibility of a downside surprise.

While analysts are expecting earnings to drop significantly YoY, I would argue that the current P/E of 3.06 and forward P/E of 6.47 overly discount future earnings. MTGE went from earning $1.72 per share two years ago to earning $8.40 per share last year, so last year was a bit of an outlier. Earnings come out on July 30th. Analysts expect earnings of .78 per share this quarter and are expecting them to earn about $3.15-3.20 per share for the full year. The earnings decline is more about returning to a "mean growth rate" than about some drastic trouble facing the company.


In the previous earnings call, before U.S. bonds started really tanking, the CEO stated in the conference call:

I really want to stress that our hedges, including swaptions, are specifically tailored to protect the portfolio against price declines in our assets that result from large moves in interest rates.

Later in the earnings call, they talked further about their hedging. It is interesting information if you wonder how a mortgage REIT does hedge:

...We use a combination of swaps, treasuries, and swaptions to hedge our asset as each of these instruments have their own unique advantages and disadvantages in different environments.

Swaps, for example, tend to correlate well with mortgages in most environments for smaller rate moves, but do not provide any protection against the negative convexity inherent in mortgage assets. For this reason, our pay fixed swap position usually makes up the largest component of our overall hedge portfolio, but is insufficient as the only hedge.

Our treasury hedges give us incremental protection against the change in the Fed's asset purchase program and QE3 includes both agency MBS and treasury securities. So in a scenario where the Fed tapers or concludes QE3, these hedges should perform well for us. Treasuries are also the most liquid instrument in the world, and as such, transaction costs are minimal.

... Lastly, our swaption hedges give us protection against large increases in rates and protection against increases in interest rate volatility. As such, these hedges are critical to protecting our portfolio against large rate moves, but are relatively ineffective at providing protection against small changes in interest rates, like what we experienced last quarter.

The company also noted that they adjusted their hedges by increasing them to match growth in portfolio assets and extended the swap maturities. We shall see how interest rate changes affect their holdings and how well hedged they were, but they believe that they were in a good position for a "taper move."

Additionally, I have heard a fixed income manager say that management at MTGE is top notch, so there is reason to believe that they hedged properly, but we shall see in the earnings call.


You can see on the chart below that MTGE saw significant selling over the past two months, but it has bounced since. If it is going to really reverse downward again, it is likely to do so when it hits the cloud/38% convergence at $20. Other levels of resistance will be $21.40 and $22.60 where the next major Fibonacci levels are. I will be watching them, along with any other major price action. The stock would be much more bullish looking if it could break through the cloud, and stay above the Tenkan (green line) and Kijun (pink line) while doing so.

(Click to enlarge)

The Play

If you like dividends, then a company like MTGE, which has sold off considerably the past two months, might bear consideration for your portfolio. At an 18% dividend rate and solid management and finances, this company could provide solid long-term capital appreciation.

You need to decide what you think the Fed's intentions will be going forward, but assuming low short rates into 2015, REITs like this could remain solid. If you combine that with the process of selling covered calls (say about 3-5% out of the money; but be careful not to do it when they are paying a dividend), along with reinvesting the dividends into the stock, it would lower your cost basis tremendously.

I am actually considering adding this to my retirement account, enrolling it into a DRIP, and selling covered calls. However, I will not do that before earnings. In fact, I will wait until September to see how actual tapering affects rates. That should also give me a chance to watch whether buyers remain interested or if sellers take back over.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: We do not know your personal financial situation, so the information contained in this article represents an opinion, and should not be construed as personalized investment advice. Past performance is no guarantee of future results. Do your own research on individual issues.