An mREIT Play With No Risk? Hedging Two Harbors Investment Corp.

Oct.11.13 | About: Two Harbors (TWO)

mREITs are interest rate sensitive. Meaning that as Treasury yields rise market prices of mREITs fall. The position is long mREITs - I like Two Harbors Investment Corp (NYSE:TWO) and long an ETF that is short the Treasury 10-year (NASDAQ:DTYS). The idea here is to rake in the 10-12% dividends from TWO with less price volatility risk. The ETF has expenses of ~0.5% a year. An equal weighted portfolio of TWO and DTYS should yield ~6% return with greatly reduced risk.

The problem with most hedging strategies is that they require you to manage contracts and expiration dates... who really has time for that? Besides, they are expensive! A great alternative is the ETF market. More and more ETFs are being created that short sectors, indices, commodities and a lot more. Most of which charge an expense ratio of less than 1%. Shorting can be scary, but I infer that ETFs make it much simpler, cost effective, and approachable.

A little about mREITs:

mREITs (Mortgage Real Estate Investment Trust) are a special kind of company that is available for trading on most stock market exchanges. The general business model for an mREIT is as follows: A company is created with investor equity (capitalized) and registers with the IRS as a REIT. REITs have special tax privileges and specific tax rules they must follow. The newly capitalized REIT company purchase real estate products such as mortgage backed securities (MBS). If the company primarily purchases one type of real estate product, like MBSs, they will become known for that product. Such is the case for TWO purchasing MBS products and becoming known as an mREIT. The MBSs purchased by the company produce income that stems from the interest payments made by the homeowners that make up the MBS. The mREIT company then leverages these performing assets in the Repo Market. In other words, the mREIT borrows short term money in exchange for collateral (their MBSs). The borrowed money is then used to purchase more MBSs.

A little about the ETF:

iPath US Treasury 10-year Bear ETN is an exchange traded fund that seeks to replicate the inverse returns of 10-year Treasury futures. As 10-year Treasury yields move, the fund's price moves in the opposite direction.

The 10-year Treasury rates have a long history of high correlation with mortgage rates. In general, most mortgages payoff on average in around 10 years. Therefore, mortgage companies, like banks, tend to lend at a premium above 10-year Treasury rates. Treasury rates are considered the risk-free rate and a good starting point for risk and return evaluation. Another way to view it is that the difference between the 10-year Treasury rate and average available mortgage rate is the 'risk premium'. Now, there is a widely known understanding that mortgage rates actually are determined by MBS creation coupon rate demands. If a to-be MBS is requiring a 4% coupon for lenders to pay into, a lender would originate loans at 4.5% to cover the G-fees and requirements of securitization. But this is more complicated to explain and would require another article to fully explore. The important notion is that 10-year Treasury rates and MBS coupon rates are highly correlated and their price movements directly affect the market value of mREITs.

How the play works:

(click to enlarge)TWO and DTYS year to date IndexedClick to enlargeThe above graph shows normalized returns of TWO (in Blue and DTYS (in red) since the beginning of the year. We can clearly see the inverse relationship to returns the mREIT and ETF have. As one raises in value, the other falls. More or less negating price returns, however, dividends still remain.

Now you can't cut out all the variability of price returns, but it can be greatly reduced. If your anything like me, you are having a hard time finding value out there in the market and may have a lot of cash waiting on the sidelines driving you nuts. This mREIT/ETF play may provide you a decent yield while you await for better buying opportunities.

Warning: I do believe this relationship with the 10 year and mREIT returns may become debunked once the Fed announces that they will raise the Fed Funds target. The sheer announcement would cause the Repo market to spike. This would kill mREIT's spread and causes a large decrease in dividends payments.

Personally, I believe that the raising of the Fed Funds rate will also queue the next large market crash and economic recession, but that is for another article.

Best of luck, and stay level headed.

Disclosure: I am long TWO, DTYS. 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.