Western Asset Mortgage Capital Corp. (WMC) is a REIT. It is focused on investing in, financing, and managing primarily Agency RMBS. It IPO'd May 15, 2012, so it has limited history. WMC's investment strategy focuses on Agency RMBS, but WMC also invests in non-Agency RMBS, CMBS, and other asset-backed securities. WMC is externally managed by the Western Asset Management Company, a global leader in diversified fixed-income management. WMC currently pays a whopping 23.18% annual dividend. At that rate it could almost pay for itself in four years.
In Q3 WMC's book value fell from $17.39 as of June 30, 2013 to $16.81 as of September 30, 2013 (-$0.58 per share or -3.33%). This sounds terrible until you consider the dividend was $0.90 per share for Q3 2013. Combining the book value loss and the dividend payout, WMC had a total economic return of +$0.32 (or +1.84%) for Q3 2013 (+7.36% annualized). For a troubled quarter, this was a good result. Core earnings were $20.1 million (or $0.83 per diluted share). WMC had net income of only $7.5 million ($0.31 per diluted share); but much of this was related to unrealized losses. WMC had a weighted average portfolio yield of 3.42% on Agency and Non-Agency MBS, including IO (interest only) securities. It had a 1.14% weighted average effective cost of financing, including swaps and linked transactions. WMC had a 2.28% weighted average net interest spread on Agency and Non-Agency MBS, including IO securities. The portfolio fair value was $3.6B as of September 30, 2013. The constant prepayment rate for WMC's Agency RMBS portfolio was 5.3% for Q3 2013. Leverage was 81.x as of September 30, 2013 (9.0x when adjusted for net TBA positions).
The table below shows WMC's portfolio as of September 30, 2013.
As you can see, WMC has completely gotten rid of its Agency 30-year fixed rate 3.0% coupon RMBS. This is good, but it still has a lot of 3.5% coupon Agency 30-year fixed rate RMBS ($1.58B in fair value). In other words some of the extension risk has been removed, but WMC is still very vulnerable to extension risk with a large amount of Agency 30 year fixed rate RMBS. Plus the hedges to protect the Agency 30 year fixed rate RMBS are more expensive than those of the Agency 15 year fixed rate RMBS (or the Agency 20-year fixed rate RMBS).
How much of a worry are interest rates and mortgage rates? They are a significant one. The chart of the 10 year US Treasury Note yield below shows that they have been headed upward again lately.
The yields have been rising again since late October 2013. On top of this BlackRock's forecast for the end of 2014 is in the range of 3.25% to 3.50%. This is a headwind for WMC, but it does not appear to be an insurmountable one. Further it is unclear that BlackRock will necessarily be precisely correct; and WMC has started to diversify its portfolio into Non-Agency RMBS, which are currently available at large discounts to face value. This allows for large profits if the economy improves, which it has been doing. In other words, if interest rates rise with a recovering economy, the fair value of the Non-Agency RMBS would likely go up with improving housing prices and housing sales. Further HARP 3.0 could be approved at any time. This is supposed to allow non-Agency mortgage holders to be able to refinance at lower rates with the help of the government. This would mean extra profits in the non-Agency area in the near term; and as WMC expands its investments in this area, it should provide further protection against the usual consequences of economic improvement -- higher interest rates and mortgage rates.
WMC also has significant hedges against interest rate increases. The table below shows WMC's interest rate swaps holdings as of September 30, 2013.
The above hedges should provide substantial protection against interest rate and mortgage rate increases.
The one year chart of the 30-year Fannie Mae 3.5% RMBS provides some actual data on how WMC has been doing in Q4 2013. The 3.5% 30-year fixed rate Agency RMBS is the largest single holding in WMC's Agency portfolio at about $1.58B in estimated fair value.
The chart above shows that the 3.5% RMBS has lost about 1% in book value in Q4 2013. With leverage at 8.1x, this might mean approximately an 8% loss. However, with the interest rate hedges (see the 10 year US Treasury Note yield chart above), this loss should be cut by at least two thirds. This still amounts to roughly a 3% loss, but there is no way of knowing exactly what will happen for the rest of Q4 2013. WMC might end up with no loss. Plus it will not have the losses it incurred in getting rid of its 3.0% Agency RMBS in a troubled market. The Q4 losses could be substantially below what I have suggested above. Even if they are as large as I have suggested (or they get worse), WMC is paying a 23.18% annual dividend currently (or about 5.80% per quarter). This means WMC is not currently close to actually having a negative economic return for Q4 2013. It may mean that barring huge spikes in interest rates in the near future, WMC may not have another quarter with a negative economic return for some time. In fact, it may have some quarters next year in which it accrues book value (and pays a great dividend). Admittedly, the dividend rate is a little at risk with a dividend of $0.90 for Q3 2013 and Q3 Core Earnings of only $0.83. However, WMC is not at risk of a huge interest rate cut. It is only at risk of a small cut; and that may not occur. Even with a dividend of $0.80, WMC would pay a 20.6% annual dividend, which is outstanding. Meanwhile WMC at its closing price of $15.53 on December 6, 2013 is trading at a 7.6% discount to book value. It has upside potential. It is a buy, especially with its fledgling move into Non-Agency RMBS investment.
The two year chart of WMC provides some technical direction for this trade.
The slow stochastic sub chart shows that WMC is near oversold levels. The main chart shows that WMC seems to be finding support at current levels. It appears to have bottomed; and there is not good reason at this time to think that it will go demonstrably lower. With its great dividend, it is likely to move sideways to up from here. With this in mind, it is hard to pass up WMC's 23.18% annual dividend. Further insiders have bought 427,750 more shares (+4.3%) in the last 6 months. Insider buying is usually a buy signal. The mean analyst recommendation is 2.7 (a high hold). Its CAPS rating is four stars (a buy). WMC is a buy for income investors.
Keep in mind we could see the US economy slow in 1H 2014. If this occurs, interest rates might fall instead of rising. Then the book value of WMC would almost certainly go up; and it would still have a great dividend.
Note: Some of the fundamental fiscal data above is from Yahoo Finance.
Good Luck Trading.