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Capstead Mortgage Co. (NYSE:CMO) is a mortgage REIT. It has a leveraged investment portfolio of exclusively Agency ARM RMBS. The ARMs (adjustable rate mortgages) are short reset ARMs by design. This generally results in smaller fluctuations in portfolio values from changes in interest rates compared to fixed-rate RMBS portfolios. CMO is recognized as the most defensively positioned Agency mortgage REIT. It is self-managed; and its management team is experienced. Its top four executives have over 85 years of combined mortgage finance industry experience. CMO is not a newcomer to the industry. It was started in 1985. It has a five-year compound annual total return of 18.0%, which exceeds that of the NAREIT Mortgage REIT Index. It is currently paying a very respectable 9.83% annual dividend (as of the close on January 31, 2014.

In Q3 2013 it saw very bizarre results given its strategy. This seemed mostly due to the CPR (constant prepayment rate) ballooning to 25.5% for Q3 2013. However, this anomaly in the market is behind the company. In Q4 2013, CMO saw its average CPR for Q4 2013 drop to 17.14% (about a 33% drop quarter over quarter). This led to a $14.2 million decrease in investment premium amortization charges. Keep in mind that Agency ARMs usually trade at a premium to face value. Therefore the company usually loses money when they are paid off early (it loses the premium to face value) even though they are guaranteed by the US government.

Another reason CMO's portfolio performed so well is that it has only short term hybrid ARMs (3 and 5 year Hybrid ARMs). To explain, a hybrid ARM blends the characteristics of an ARM and a fixed rate mortgage. The specified yearly period is the length of the fixed rate mortgage. Then the mortgage converts over to an adjustable rate mortgage. When interest rates go up, as they did in Q4 2013 (from 2.61% to 3.03% on the 10 year US Treasury Note yield from September 30, 2013 to December 31, 2013), the book value of Agency fixed rate mortgages usually goes down. When the fixed rate mortgage are 30 year Agency fixed rate mortgages, they go down in book value faster than 15 year Agency fixed rate mortgages. The same general principle applies to Agency Hybrid ARMs. Since CMO has low time to reset Hybrid ARMs, it lost much less due to rising interest rates in Q4 2013 than companies with higher time to reset Hybrid ARMs. Plus it gained net interest rate margin. This is by design on CMO's part; and CMO's Q4 2013 results reflect the astuteness of this strategy.

How well did CMO do in Q4 2013? It generated earnings of $37.0 million or $0.35 per diluted common share. Its financing spreads increased 38 bps to 1.25%. Its net interest margins related to its residential mortgage investments yielded profits of $43.1 million compared to $30.9 million in Q3 2013. Its average portfolio CPR declined 33% to 17.14%. Its book value increased $0.12 to $12.47 per common share. It paid a dividend of $0.31 per common share (on January 20, 2014). Since the 10 year US Treasury Note yield rose 42 bps during Q4 2013, the above are exemplary earnings statistics for an Agency mortgage REIT. Further they show that the dividend is in no danger of being cut in the near term. The leverage at the end of Q4 2013 was 8.52x, which is close to where the company says it wants it.

The following table shows CMO's portfolio as of December 31, 2013. "Current-reset" ARMs are defined as 18 months or less to reset.

(click to enlarge)

This looks like a good, solid portfolio; and it should stand CMO in good stead in quarters to come. The only gotcha seems to be that with the now lower CPRs, buying new short time to reset Agency ARMs is expensive. In other words it is expensive to replace the run-off. CMO expects to replace most of its current-reset run-off by allowing the older reset Hybrids to age (slowly become current-reset Hybrids). In this way it will avoid paying "too high" prices for current-reset Agency Hybrid ARMs.

The guidance was very vague. However, the generalizations did sound overall positive for 2014. Plus CMO expects CPRs to perhaps move into the mid-teen area. This should help results. The relatively bad news for investors is that the 10 year US Treasury Note yield has been going down dramatically since the end of Q4 2013. The yield has fallen from 3.03% on December 31, 2013 to 2.66% as of this writing on February 3, 2014 (-37 bps). This will probably translate into a contraction of the net interest spread for Q1 2014. However, that should not be too drastic. Plus the expected decrease in the average CPR of CMO's portfolio in Q1 2014 should help increase earnings rather than decrease them. In all CMO should still do well in Q1 2014. It is a buy. Remember it is an Agency REIT, so its assets have the backing of the US government. This means it should be a relatively safe investment in a potentially very troubled market.

The two year chart of CMO provides some technical direction for this trade.

(click to enlarge)

The slow stochastic sub chart shows that CMO is near overbought levels. The main chart shows that CMO has been consolidating for more than a year. It could head upward or downward from here. Since the book value is $12.47 per common share as of December 31, 2013, the stock is trading at a reasonable valuation at $12.62 as of the close on January 31, 2014. When many mortgage REIT equities are trading at large discounts to book value, the fact that CMO is trading near book value is a very positive statement of the regard most investors have for this stock. Investors can consider averaging in over 2014.

The main caveat for a buy is the direction of the overall market. This has been showing weakness of late. The overall market is both overpriced and overbought. It could head downward significantly from here. The situation in emerging markets is very worrisome too. There is worry of contagion to the EU and others. This could worsen an already bad economic situation in the EU and vice versa. That in turn would be bad for both the US and China. It would be bad for both of their stock markets. The only good news in that regard is that CMO has a Beta of only 0.44. It should be more immune than most to being dragged down by the overall market. This is another reason that it is a buy. CAPS only gives it three stars (a hold); but in this time of uncertain interest rates, its strategy bumps that up to a buy. If investors can hold onto this stock long term, it should prove to be a highly profitable investment. Remember it has a dividend of nearly 10%; and the Fed seems unlikely to let the US housing market collapse again in the next couple of years.

NOTE: Some of the fundamental financial data above is from Yahoo Finance.

Good Luck Trading.

Source: Capstead Mortgage Proves The Worth Of Its Investment Strategy In Q4 2013