In the 1976 classic thriller Marathon Man, the famous exchange between Nazi war criminal Dr. Christian Szell (Sir Laurence Olivier) and Babe Levy (Dustin Hoffman) has Szell repeating the phrase "Is it safe?" Hoffman's character has no idea what he is talking about, but Szell keeps repeating, with no additional information or detail, that singular phrase: is it safe ?
I do not know if he has seen the movie, but DoubleLine CEO Jeffrey Gundlach, one of the more prescient and visible bond gurus in recent years, has lately proclaimed that as far as the Mortgage REITs are concerned, yes, it IS safe. While acknowledging that the size and speed of the move in interest rates caught him by surprise, Gundlach recently stated he believes that rates will not move much above 3.10%. Gundlach believes that neither the U.S. or global financial centers can tolerate a complete repeal of the rate decline seen since early-2011 when the 10-year was at 3.75%. That was prior to the U.S. debt downgrade and the near-implosion of the EU and Euro. As a result, Gundlach has been bullish on both Mortgage REITs and even closed-end bond funds, stating that their leveraged yields will offset any miniscule price declines over the next 12 months and afford patient investors returns in the 8-12% range, possibly higher.
Mortgage REIT investors can feel a bit unnerved in recent months if they feel like Hoffman's Babe Levy character about to have an unwanted dental probe. The unprecedented rise in interest rates since May has surprised virtually all market participants and investors in speed and magnitude. From 1.87% at the end of March and 1.66% on May 1st, the 10-year soared to 2.52% on June 30th, spiked 20 bp. alone on July 5th following the Non-Farm Payroll number, and continued to rise in July and August with a recent after-hours move to 3.00% last Thursday.(click to enlarge)
But that rise in rates has largely already reflected falling bond prices and dividend reductions. The sector has moved to a discount to book value, one of the reasons for Gundlach's optimism:(click to enlarge)
MBS prices have been doubly affected. First, the general rise in interest rates has directly impacted all bond investments, including mortgage-backed securities. Second, the spreads that MBS normally trade at have widened relative to Treasury yields as interest rate volatility rose in recent months. This rise in volatility was a direct result of the difficulties in hedging the rise in rates as well as the rapid selling of MBS bonds by mREITs and other MBS investors. JP Morgan MBS strategists estimated that in Q2 the 15 largest mREITs unloaded almost $20 billion in MBS to delever, meet margin calls, or re-position their portfolios.
The good news for mREITs and their investors is that unless one foresees a return of the 1970's rate environment with an endless cycle of higher rates and falling bond prices, the bulk of the damage - if not ALL of it - should be over. This is simply basic math and bond mathematics. On a pure rate percentage, when rates were artificially depressed earlier this year any rise in rates was bound to be larger percentage-wise. Indeed, rates rose 60% and 80% from the March 31st and May 1st levels, and did so in record time. To see a 60% rise from current levels would imply a 10-year Treasury north of 4.60%, a level not seen since before the 2008-09 Credit Crisis.
From a duration perspective, if we assume a 10-Year Treasury has a duration of 9 years, then the rise in rates since the May bottom has knocked the price down just over 11%. While a final move up to 3.10% or even 3.25-3.50% might be scary, the price damage will be less than that done earlier (a 3-4% price decline if we move into the low-3's). While MBS suffer from negative convexity - the extension in duration for mortgages as rates rise - the fears cited by some from a dramatic rise as we have seen the last 5 months has not come to pass.
In Q2 2013, many of the Agency mREITs did two things to reduce future sensitivity to rate rises and mitigate any negative convexity from rising rates. First, they shifted from 30-year paper to 15-year mortgages. While this reduces portfolio yield, it is far easier to hedge the shorter maturity mortgages which also have much less price and extension risk than their longer counterparts. Plus, the general rise in rates made ROEs from the shorter paper much more attractive than they had been just 6 months earlier. Second, many of the mREITs increased their hedge books via swaps and swaptions. American Capital Agency (AGNC), for instance, both lengthened and increased the overall hedge book to the point where net portfolio duration was shortened to about 0.5 years. That is much less duration exposure than all but the shortest-duration hybrid ARM securities.
While they cannot issue equity to immediately grab the higher returns, we have seen a 500 bp. rise in ROEs from just a few months ago. These higher ROEs are now equal to or exceed the stated dividend yields for virtually all of the mREITs, a situation that was not present a few months ago when ROEs were 9-12% and dividend yields were a few hundred basis points higher:(click to enlarge)
The reason for the carnage in book values and stock prices in preceding quarters - and the reason for optimism going forward - can be seen in the spreads available today in the market. Even without the Fed beginning Operation Taper, the risk-reward for MBS and mREIT investors is at its most favorable since 2011. The MBS to overnight repo spreads have widened dramatically in recent months as short-rates are steady but long-rates rose dramatically (all charts courtesy of Morgan Stanley):(click to enlarge)
Swap rates have risen, reflecting the overall rise in yields plus the increased rate volatility. However, they are still only at 2010-11 levels, a great time to be an mREIT investor:(click to enlarge)
Fortunately, the rise in investment yields has exceeded the increased hedging/swap costs for those who need to add swaps (those who already had them in their portfolios have seen nice gains). Net spreads have increased, as you can see from the graph below. Note that spreads in the latest week range from 53-245 bp., whereas for all of 2012 and for most of 2013 they were much lower and in some cases, negative:(click to enlarge)
OK, we have made the point that much of the downside is past and any further incremental rise in rates is largely reflected in the sector trading at rich dividend yields averaging 15% even after recent dividend cuts. That and discounts to book value approximating 15% make for an attractive entry point. Which stocks to buy ? Glad you asked….
American Capital Agency : Utilizing higher-leverage and 30-year paper in the past was a good strategy for 2008-12 but not now. As a result, AGNC has increased her 15-year MBS exposure to 42% from 34% while cutting 30-year paper a similar percentage. Hedges have increased resulting in the low net portfolio duration cited above. With over $1 per share in undistributed taxable income, pure-play agency mREIT AGNC should be able to hold the dividend until early-2014; the company's past history suggests they do not like more than 1 dividend change per year. The bellwether of the mREIT sector appears to be able to hold the current $1.05 dividend which equates to a stellar 18.5% dividend yield. A few quarters out AGNC should have a better handle on the speed of Fed tapering relative to then-current interest rates. In the meantime, you can buy the premier management team in the mREIT sector at 13% and 6% discounts to Q2-ending and current book value estimates, respectively.
Capstead Mortgage (CMO): Capstead had one of the stellar performances in preserving book value among agency mREITs during Q2, validating the company's short-duration hybrid ARM focus. Other mREITs focusing on longer-duration hybrid ARMs like Hatteras Financial (HTS) got walloped on both book value and subsequent share price declines. CMO saw her book value fall only 6% in the second quarter. Should the Fed start hiking the Fed Funds rate sooner than expected - or should expectations of such hikes start to accelerate - this should accentuate CMO's relative outperformance, since rising short rates would narrow spreads for longer-duration mREITs but adjust higher for CMO's portfolio. You pay for this book value and rate protection in a reduced yield, but CMO still yields 10.7% at the recent quarterly dividend rate. Shares also sell for about a 15% discount to Q2-ending book value.
Two Harbors Investment (TWO): A hybrid mREIT that saw her book value fall a bit over 6% in Q2, TWO is managed by the super-savvy veteran fixed-income and mortgage team at Pine River Capital Management. TWO is a play on non-agency credit, as the managers have been increasing the mix of whole loans, mortgage servicing rights (MSRs), and credit sensitive loans in the portfolio during recent quarters. MSRs not only offer attractive risk-adjusted yields, they have high barriers to entry as opposed to simply buying agency or non-agency MBS for a portfolio. TWO's portfolio at June 30th totaled $16.1 billion consisting of agency MBS (76%), non-agency MBS (18%), credit sensitive loans (2%), prime jumbo loans (3%), and net economic interests in securitization (1%). TWO continues to opportunistically look for additional MSR opportunities by purchasing small servicers who lack scale and are willing sellers. TWO bought back 1 million shares at $10.50 in Q2 and the company has an authorization to buy up to 24 million more, so a persistent discount to book value should attract management's attention. 4.2 million warrants remained outstanding as of June 30th (exercise price = $10.25 per share); the warrants expire on November 7, 2013. TWO shares sell for 84% of Q2-ending book value and yield 12.8% at the current dividend run-rate.
MFA Financial (MFA): Another hybrid mREIT that performed well in Q2, with book value falling just over 7%. MFA has a 43% exposure to non-agency and the bulk of these are a few notches below the top-rung of AAA and AA-rated credits. These lower-rated investment quality bonds tend to act like negative durations during periods of rising rates, an excellent hedge. Plus, the steady improvement in the housing and real estate markets has lifted the prices of these securities, to the point where MFA has declared 2 special dividends in the last year to reflect better-than-expected appreciation in the credit portfolio. MFA still has generous reserves for credit impairment and future reversals of these charges and additional special dividends are likely. Just under 20% of the swap book matures in Q3 and Q4 2013, and with these costing 4%, savings on new lower-cost swaps should fall straight to the bottom line. Total portfolio leverage remains low at about 3x, reflecting the large weight in the lower-levered non-agency bonds. Trading at about a 10% discount to September book value (18% discount to June 30 book), MFA shares reflect a somewhat weaker credit environment in August and September. A 12.1% dividend yield before any special dividends provides ample yield support for this veteran mREIT with battle-tested management: shares have returned 12.9% annually since her 1998 IPO, versus 2.7% for the S&P 500.
Apollo Residential Mortgage (AMTG): Apollo Residential is striving to be The Comeback Kid. The portfolio took a shellacking in Q2, with book value down just over 14%. Following this relative debacle - AMTG is a hybrid but the decline was close to some of the long-duration Agency mREITs - management made the decision to basically excise interest rate risk at all costs. The agency MBS portfolio was shrunk by one-third and the overall portfolio shrunk 20%. Hedges were increased to give an overall portfolio duration of close to zero. The agency MBS portfolio should only be affected by spreads, not by rising or falling rates. The non-agency is heavily sub-prime (purchased at big discounts to par value) and itself has negative duration tendencies should rates rise further. Plus, the non-agency will continue to move up in value as housing and real estate continue to improve.
Unlike MFA, whose non-Agency portfolio consists of higher credit quality Alt-A MBS, AMTG's non-agency portfolio is concentrated in floating rate, sub-prime MBS. The floating rate nature of the MBS suggests that it has minimal interest rate exposure (like any floating rate bond). The fact that the MBS are sub-prime bodes well for further price appreciation if the economy continues to heal. The $0.70 quarterly dividend appears sustainable for a few more quarters but even a trimming of the dividend more in-line with the reduced portfolio size and yield should still generate mid-teens dividend yields. At the current share price, AMTG yields 18.7% and trades at about 85% of book value. With a dramatically reduced risk profile, AMTG represents one of the better values in the mREIT sector.
While the U.S. economy has withstood the rise in rates to date, the navigating has been much more difficult for the emerging market and EU peripheral countries. This probably caps the ultimate rise in rates well-below the 2011 peak before the U.S. debt downgrade and EU difficulties cut yields in half. With the ability to buy at 15-and-15 levels - 15% yields and 15% discounts to book value - mREITs offer one of the most compelling entry points in the last decade. This is not to say that risk are not present, but the risk-reward profile has decidedly swung more in the shareholder's favor. While a rising Fed Funds rate is something to keep an eye out for, the latest futures indicate only a 2% Fed Funds rate by July 2016, with initial 25 bp. hikes in late-2014 and early-2015. With their cost of funds largely locked in through the swaps market, small Fed Funds boosts should not impact book values anywhere near as much as soaring long rates did in recent months.
So the answer is, yes it is safe. Just be on the lookout for rapid Fed rate hikes. Or some volatility surrounding the appointment of the next Fed chairman. And of course, any thickly-accented dentist who is following you around.
Additional disclosure: The author holds positions in the 2 stocks listed above in managed portfolios plus holds positions in all 5 securities in various online portfolios.