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You’ve no doubt seen the large number of opportunistic and/or distressed asset specialists enter the mortgage REIT market. Despite not having the burden of a sizable and underperforming legacy portfolio, I have avoided most of these new issues as both unproven and untested. My focus for outperformance in the mortgage REIT market is on seasoned companies in the sector who have slowly and strategically added credit risk as the financial crisis has subsided.

(Note that I have excluded groups that invest solely in agency-backed MBS from this article because these groups manage interest rate risk, not credit risk. The run-up in price for agency securities over the past few months has eliminated much of the opportunity for these names to capitalize further on the shape of yield curve. I believe the best opportunity for outsized return now lies in managing credit risk.)

Companies that I believe have prudently and strategically added a reasonable amount of credit risk to their portfolio (and thus are poised to outperform the sector as a whole) include MFA Financial (NYSE:MFA), New York Mortgage Trust (NASDAQ:NYMT), Chimera Investment Corp. (NYSE:CIM), and Walter Investment Management (NYSE:WAC).

I like these names primarily because they are recognizing taxable income from the accretion of market discount income. Basically, because these groups bought mortgage-backed and other asset-backed securities at a significant discount, the IRS requires them to record that discount into taxable income over time as the securities season. That discount accretion income does not get recorded into GAAP earnings until the securities are sold, so GAAP understates (sometimes significantly) the amount that these REITs will be required to distribute as dividends – a fact which may be lost on the average investor.

Unlike some of their fallen comrades in the mREIT sector – think Thornburg Mortgage (OTCPK:THMRQ) and Impac Mortgage (IMPM) - these groups have a diversified portfolio strategy that involves some agency MBS holdings and very low leverage. The agency MBS provide an opportunity to access liquidity if needed and the lack of leverage on the non-agency MBS prevents cash-draining (and potentially fatal) margin calls.

Of course, over time GAAP and taxable income will have to converge, so there will be a point later in the cycle where GAAP income exceeds taxable income and the dividends will be cut.

However, I believe that for the next few quarters, taxable income will continue to exceed GAAP for the REITs I’ve singled out, supporting steady dividend increases and a resultant rise in the common stock price as investors chase yield. It’s a favorable risk/return scenario for income-oriented investors, particularly if you believe interest rates will rise sooner rather than later.

Disclosure: Author holds long positions in CIM, NYMT, and WAC and no position in MFA.

Source: Why Credit Risk at Mortgage REITs Will Yield Outsized Returns