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Just as every investor has their own investment goals and objectives, each investor has a different tolerance to risk that is unique with respect to their financial position, investment objectives, and lifestyle characteristics. Individual investors commonly seem to be under the misconception that high yield is always associated high risk, and while at times this is true, there's quite a few investment products out there that provide a high yield, but are not high risk in nature. The percentage of your portfolio you reserve for these investment products will depend on your degree of risk aversion, but regardless of what your level of risk aversion is, I'm an advocate for high yield instruments, and strongly feel any investor is capable of engaging in these types of investments with a diversified portfolio.

With that being said, I would like to highlight Capstead Mortgage (NYSE:CMO), a well diversified mortgage REIT that has escaped my attention for a while now. Like other mortgage REITs, CMO is a high yield instrument offering shareholders' a divided yield of 10.51%. In terms of market capitalization, CMO is on the smaller side at only $1.13bn, however its financial position is considerably strong given its cash position is almost 20% of its entire market capitalization. With this amount of cash on hand, shareholders' should note this equates to roughly $2.14 in cash for every share outstanding.

Furthermore, CMO is heavily undervalued based on asset valuation as well as the performance of its investment portfolio with respect to its peer group and their performance in the market. The fact CMO's market price does not reflect nearly what its truly work suggests there is a feasible investment. Therefore, the combination of CMO's suppressed valuation, management's ability to provide an adequate return on invested capital, and its sound financial position place CMO in a perfect position to offer patient investors a favorable return over the next several years.

Overview

CMO was originally founded in 1985 and exists today as the oldest publicly-traded Agency mortgage REIT. CMO hold vested interest behind its capital investments in its leveraged portfolio comprised of adjustable-rate mortgage securities, which are primarily issued and guaranteed by Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC), or Ginnie Mae. One of the key functions of these adjustable-rate securities is they reset to more current interest rates within a relatively short period of time, which is extremely advantageous because it allows for the expansion of financing spreads during a poor interest rate environment, allows financial spreads to recover after diminishing from rising interest rates, and last, it minimizes the effective duration of CMO's portfolio.

CMO's Portfolio & Short-Term Structured Strategy

As of the most recent reporting period, June 30th, CMO's portfolio of adjusted-rate mortgage securities amount to a total of $13.82bn. Over the last five years, the same investment strategy has provided a compounded return of just over 17% annually. Here's an overview highlighting some of the key components to CMO's portfolio. Glancing at the figure below, you will see the principal balance, investment premiums, the amortized cost basis, the fair market value, as well as several other metrics for its current-reset adjustable-rate mortgage securities.


(Click to enlarge)

(Source: CMO's Investor Presentation)

Broadly speaking, CMO employs a wide variety of strategies and utilized leverage to take advantage of financial spreads. But more specifically, CMO maintains a short-term orientation focused on targeting short-duration adjustable-rate mortgage securities increased with 2-year interest rate swap agreements. The ability for CMO's securities to reset with more current interest rates is the core part of its strategy that allows it to adequately adjust to a constantly changing interest rate environment, and ultimately, boost its financial position and performance of its peers.

(Source: CMO's Investor Presentation)

The ability for CMO's securities to reset with more current interest rates is the core part of its strategy that allows it to adequately adjust to a constantly changing interest rate environment, and ultimately, boost its financial position and performance of its peers.

The Implications of CMO's Trading Correlation With The 10-Year Treasury

There's a common misconception among market participants who trade CMO, and the misconception is that CMO provides fairly decent exposure to long-term interest rates. While you may be thinking to yourself that this does not pertain to you personally, think again because it has influencing control over CMO's valuation. Based on historical trends, it appears many individual investors mistakenly trade CMO along with the 10-year Treasury and other similar REITs. From looking at the graph below, you will see the percentage change in the 10-Year Treasury is relatively correlated to the percentage changes in CMO's price.

10 Year Treasury Rate Chart
(Click to enlarge)

10 Year Treasury Rate data by YCharts

While this trading strategy is not the best, it would work if CMO provided exposure to long-term interest rates, but the reality is that CMO actually provides very little exposure to long-term interest rates. As a result, this misunderstanding creates a good amount of negativity, and I strongly feel this is the underlying reason CMO consistently trades below its fair book value.

Valuation

Looking at CMO's valuation, I will have to say I think it's fairly attractively priced at under $12 per share. As mentioned in the discussion regarding its trading correlation, we know CMO consistently trades below its fair book value. And if we take a look at the structure of the assets and liabilities on its balance sheet, we'll see that CMO's fair book value is $12.94 per share, which can also be expressed just as well through its P/B ratio. Looking below, you will see its current P/B ratio is only 0.91.

CMO Price / Book Value Chart
(Click to enlarge)

CMO Price / Book Value data by YCharts

On the earnings side, CMO's EPS have increased by about 51% over the last five years. Despite earnings have grown slower this year than investors would have like to see, analysts estimates for 2014 are quite favorable. As of now, analysts are projecting roughly 30% in EPS growth for 2014, which is more than half of the overall growth its earnings have seen in the last five years. Six of the seven analysts who cover this REIT are bullish and have a mean price target of $13.25, which implies an upside of about 12%.

Investor Concern & Final Thoughts

While I feel CMO is a solid REIT to invest in, there are several things investors need to evaluate beforehand. First, is the volatility and risk associated with its stock price, which we can analyze by simply computing several statistics including its beta and standard deviation. Using CMO's monthly holding period returns for the last two years, I computed a firm-specific beta of 0.45 and a standard deviation of only 4.5%. Give the market has a beta of one, we can eliminate its beta as an area of concern since CMO's is lower than the market beta. During this same time period, the overall market revealed a standard deviation of about 6.3%, which is a signal that CMO's returns are less volatile than the returns of the overall market. Conclusively, CMO's security price reveals an extremely low level of volatility, and investors should eliminate any concerns regarding dramatic short-term price fluctuations.

Now that we've eliminated, the risk within its security price, we need to focus on other risks at hand we discussed earlier such as its trading correlation to longer-term rates. Going forward, the tendency for investors to trade CMO with other longer-term securities such as the 10-year Treasury have the ability to continue negatively impacting CMO's valuation. As we've seen, this issue continues to force CMO to trade below its book value, and over time, as its portfolio and total value as a company continues to grow, this could prevent CMO from reaching its full potential in the market. Overall, the underlying assets within CMO's portfolio are solid and have the potential to provide investors with a favorable return over the next several years. Additionally, its short-term oriented investment strategy is perfectly positioned to take advantage of today's interest rate environment. And despite its trading correlation with longer-term rates, there is plenty of room for investors to retain future profits from appreciation in its share price.

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.