As many followers of the mortgage real estate investment trusts (mREITs) know, the sector has been battered. My top holdings in the space, Annaly Capital (NLY) and American Capital (AGNC), have plummeted in 2013, which has primarily been in response to three key concerns. First was the fact that the Federal Reserve may slow or cease its mortgage asset purchases sometime this year. Second was the fear that rising interest rates) will crush portfolio holdings of the mREITs. Third, there have been some true issues with quarterly performances. I still continue to own NLY and AGNC. Yet, many of you still reach out on a daily basis looking for alternatives. You like yield, you want potential growth. While I believe NLY and AGNC can return to greatness as they transition to the new environment, a young company is quickly capturing my attention due to its unique structure. While this company is transitioning in the new environment, just like AGNC and NLY, I think it has the potential to be a real strong source of income in a tax favored account such as an IRA or ESA. Thus for those tired of NLY and AGNC, a company I'd like to discuss is Javelin Mortgage Investment (JMI).
Who is JMI?
So what does JMI do? JMI is pretty young company. The company went public less than a year ago on October 3rd, 2012. When shares began trading, about 6.5 million shares exchanged hands on day one and the stock closed trading at $19.60 per share. However, the offering wasn't your normal IPO, in the fact that it was a true new issue. The offering allowed management to implement a new investment strategy that protects the shareholders of one firm from way too much risk, whilst simultaneously attracting new investment. It should be noted that another offering to raise cash for investments was conducted in the second quarter, an offering of 6 million shares bringing the total float to 13.5 million shares outstanding. JMI is a bit riskier than other companies in the mREIT space given its hybrid nature and the fact that it doesn't just invest in the safer agency backed securities. Rather, JMI is engaged in investing primarily in hybrid adjustable rate, adjustable rate and fixed rate mortgage backed securities and mortgage loans. Some of these securities are issued or guaranteed by a U.S. Government-sponsored entity or guaranteed by the Government National Mortgage Administration and other holdings are backed by residential and/or commercial mortgages. At the discretion of management, JMI may also invest in collateralized commercial mortgage backed securities and other mortgage related investments, including mortgage loans, mortgage related derivatives and mortgage servicing rights. The team that runs JMI comes from the parent company of the same name behind the popular Armour Residential REIT (ARR).
How Does JMI Make Money?
Just like AGNC and NLY, there is a basic formula that JMI uses to make money. JMI pretty much borrows money and lends mortgage backed securities. So that takes us to the next question, what is a mortgage backed security? Well, mortgage backed securities are essentially debt obligations that represent claims to the cash flows from pools of mortgage loans. These can be residential or commercial in nature though JMI tends to work primarily in the residential space, but also deals with commercial mortgage backed securities. More on mortgage backed securities can be found in detail here. JMI is a hybrid REIT which does invests mostly in residential securities, both agency and non-agency based, as well as adjustable rate and fixed rate products. It has a smaller exposure to commercial assets.
Now, what feeds into their profits? The interest rate that JMI borrows at and the interest rate they lend at is called the interest rate spread or simply the spread. As I have stated many times before, this metric is absolutely key and is one that you must assess and keep your eye when owning JMI or any other mREIT. JMI then profits from this spread, but does so how? Well they borrow at the 2 year Treasury rate and lend at the 10 year Treasury rate. Or, they borrow the 10 year and lend to the 30 year. All they are really doing is borrowing at a lower cost item and then lending at a higher rate, generating a spread and pocketing the difference. If necessary, the company can and often does increase their exposure and risk when conditions call for it. This is called leverage, which allows potential profits to be magnified. This is when they lend further out on the curve, maybe to 15, 20 or even 30 years from funds borrowed at the lowest rates. This leverage is risky but can lead to huge profits. JMI often carries a moderate to moderately high amount of leverage. For now, lets go beyond the basics and look into the spread.
A Key Measure, JMI's Spread on Interest Rates
Interest rates were moving wildly during the quarter ending in June and I had honestly expected the interest rate spread to actually improve for most mREITs versus Q1 as I believed that the cost of borrowing would rise at a slower pace compared to the yield being returned from investments. Well, in the case of JMI I was wrong, but there are some hidden positives to being incorrect on this assumption. The net interest rate spread dropped from 1.96% to 1.75% quarter over quarter. While it did go down, this spread is still incredibly large. For comparison purposes, AGNC's spread was 1.68% and NLY's 0.98%. Let's look at this a bit more to see where the assets and yields stand. First, JMI's asset yield on its agency security portfolio for the quarter was 2.99%, compared to 2.95% for the first quarter. Furthermore, JMI's average cost of funds (derived from the cost of repurchase agreements, other debt and interest rate swaps) increased 16 basis points to 1.2% for the second quarter, from 1.04% for the first quarter, due to higher average swap costs associated with entering into longer dated swaps during the quarter. As an example of the rebalancing effort, the company has sold approximately $329.5 million of agency securities resulting in the company taking realized capital losses of approximately $27.6 million. These capital losses will generally be available to offset capital gains realized in the years 2013 through 2018, but cash needed to be raised to help enter reshape the holdings of the portfolio.
All things considered, the cost to borrow rose while the average yield remained exceptionally high at just under 3%. Thus, earnings potentials as a result from the interest rate spread alone have slightly decreased, but these numbers reflect what was occurring in the second quarter. Management has been busy reshaping the portfolio in response to the volatile environment in Q1 and Q2. Thus, a good portion of the increase in the cost to borrow funds was a result of this rebalancing effort. Furthermore, 1.75% for the overall spread is incredibly strong and in this business we want this number to be as high as possible. This statistic is one of the first things I examine when looking over the performance of any mREIT. Overall, it was strong, but I expected the spread to widen.
How About Recent Earnings?
Overall, JMI's second quarter earnings report looked really good. The numbers certainly were better than both AGNC's second quarter and NLY's, though one could argue the comparison isn't fair, given the difference in structure between the companies. I disagree. Furthermore, I am long all of these companies, and believe JMI's performance was indeed superior. JMI reported a bountiful GAAP earnings of $3.56 per common share, comprised or net income of $38.2 million per common share. While this number is important, we also care about the taxable REIT income, as this is how we as shareholders are paid our dividends. The company has to pay at least 90% of this income to shareholders to stay in tax favored status as a REIT. JMI's estimated taxable REIT income was $6.5 million. Recall that $7.9 million was paid out in dividends because the company paid $0.23 per month. Therefore the dividends paid out exceeded taxable income so the funds had to be drawn out of other sources (eg the money raised in recent public offerings, or undistributed funds). Such activity is not unheard of as both NLY and AGNC had done this in the past as well. In JMI's case, they utilized some of the available $2.7 million in undistributed funds to cover the dividend. However, the company here in Q3 did have to cut the dividend to $0.15 per share for October, November and December payments, following AGNC's and NLY's cuts.
People sell stock for all sorts of reasons, but they buy stock for one reason, and one reason only. They see value and want to make money. That being said, there have been insiders at JMI who purchased a number of shares in the second quarter. No one is selling. Figure 2 has the details.
Figure 2. Javelin Mortgage Investment Insider Trades In Last Six Months
Number of Shares Purchased
Clearly, insiders believe the company will do well going forward. Prior to this wave of buying, there had been no insider trades since just after the stock IPOed. Insider buying is usually a sign of strength, particularly when there is a wave of purchases close together when there had been none prior. Couple this with the fact that there has been no selling, and we have a real bullish setup. Most of these purchases were at around the quarter end book value for Q2, with the exception of John Chrystal's May 14th purchase. Most of these purchases are now under water by about 20%. If there is any further buying in the next few weeks, it will be a strong buy signal, couple with the fact that the stock price has stabilized in the last two weeks. However, those who buy and hold the stock at current levels and subsequently reinvest their dividends could double their money in four years (assuming a constant yield and share price). Thus, this 20% loss could easily be made up by the dividends alone.
What Are The Risks?
Much like AGNC and NLY, the risks with JMI are similar in nature. The rate at which JMI borrows is key to profiting. This is one reason to care about the Fed. Right now, they have a zero interest rate policy in place. This keeps shorter term interest rates between 0 and 0.3%, so JMI can borrow money for almost nothing. This has been key to maintaining a favorable spread, borrowing at next to nothing, lending at some predetermined rate. Pressuring the spread has been Fed purchase programs which can keep the longer term interest rates low as they purchase longer term treasuries. Anything that changes the yield curve between the 2 year and 10 year or 10 and 30 year rates can cause either widening or flattening of the spread. We saw a spike in interest rates in shorter term debt from May to August (figure 1), which put massive pressure on the mREITs. Many of the spreads narrowed. This led to these stocks getting crushed.
Figure 1. Interest Rates On The Ten Year Treasury in 2013
Occasionally sometimes the rates can be higher on shorter term debt than on longer term debt. This is a dangerous situation for JMI and the only option is proper hedging of the portfolio, rebalancing the portfolio rapidly and/or taking on more risk. If they do not, JMI will suffer losses. We also have to beware of rapidly changing rates. The rate rises from May to August were pretty rapid. If all interest rates move higher quickly mREITs simply cannot rebalance their holdings in a timely enough fashion. Many mortgage holders will look to refinance at lower rates or prepay their mortgage down. Refinances or prepays are both good and bad for JMI. If a borrower refinances or prepays their mortgage, JMI's mortgage backed securities held for that mortgage will be paid off and JMI gets a lump sum payoff. Thus they have more money to lend, but they stop earning the interest on the loan, which can hurt revenues in the short term, potentially impact the bottom line as well.
JMI is currently trading at $11.71. At its current price of $11.71, shares are now down 40% from where shares closed on their first day of trading last October. Shares aren't heavily traded, as average volume is about 300,000 shares a day. Some of the more key metrics that really catch my eye are the things I look for in finding a successful mREIT. First is book value. JMI's last reported book value was $15.12 as of June 30, 2013. On this date, the stock was trading around $14.09, which was a 7% discount to book value. While interest rates were somewhat stable in July, August has been a bit volatile. It is likely there will be further book value erosion but I just cannot see it declining over another $3.00 (or over 20%) to where shares trade now. I think that shares are absolutely trading at a discount.
A strong consideration when investing in any mREIT is the price to earnings multiple. JMI has one of the best multiples out there, only trading at 3.1X earnings. For comparison purposes, AGNC trades at 2.8 times earnings whereas NLY trades at 3.3 times earnings, so JMI is certainly competitive in this regard. What about the dividend and yield? JMI recently reduced its monthly dividend to 15 cents per month. With this new payout it still pays an juicy 15.5% annualized yield based on its quarterly dividend of $0.45 cents. What I like about JMI, much like ARR is that it pays its dividend monthly, so investors receive $0.15 per month per share. I also like that JMI forward declares its dividends over the next three months. This $0.15 monthly dividend will be paid through December. It should be noted, that given all of the damage that has occurred in this sector, a further cut to the dividend cannot be ruled out. However, it could be maintained as well. Even with a small cut, JMI yields more than AGNC's current 13.9% and NLY's 12%. Thus, it is incredibly competitive. I would argue that those who are tired of AGNC and NLY but still interested in mREITs should seriously consider JMI.
I have a position in JMI with a cost basis of $11.13. I think the dividend having been cut down to 15 cents is now pretty safe but wouldn't be surprised to see a small cut in early 2014 to 14 cents, if needed, that would bring the yield to 14.5%, still paying out better than AGNC and NLY. However, with JMI's unique business structure leading to a more diverse portfolio than many competitors, I think it can be maintained. The most recent quarter was one of transition as the company rebalanced its hybrid portfolio to adjust to the new macro environment. While book value dropped quarter over quarter, it did so for all mREITs. The net interest rate spread is a very strong 1.75% and the company trades at a very low multiple, on par with the big boys AGNC and NLY. However, in my estimation JMI has been performing as well if not better than both of these companies during this volatile quarter. Furthermore, the insider buys are a real strong bullish signal, especially if we see further buying in 2013.
With interest rates settling down from their recent volatility and so long as management can execute their transitional plan effectively, I think the stock has a real favorable risk reward ratio. My downside target is $11.00 with my upside target being $15.00 by year end. At current price levels this represents either a loss of 7% or a gain of 28%. It is worth noting these figures don't even take into account the dividends you will be paid which cushions the downside risk and balloons the upside potential. Therefore JMI is worth a serious look for mREIT investors and could be considered over NLY and AGNC.