MFA Is A Buy On High Asset Yield And Large Spread

Feb.27.14 | About: MFA Financial, (MFA)

MFA is managing a risky portfolio but is getting good returns despite the risk. It is reporting an asset yield of 4.05% while many other REITs are struggling to keep their yield close to 3%. Furthermore, MFA has one of the highest interest rate spreads in the industry and the consistent dividend levels, including special dividends, make this stock worth investing in.

Introduction

MFA Financial, Inc. (NYSE:MFA) is a real estate investment (REIT) company which is involved in only the mortgage side of REITs. It invests and manages portfolios of mortgage backed securities (MBS) dealing with both agency and non-agency mortgages. Agency mortgages are backed by a government agency (Fannie Mae, Freddie Mac or Ginnie Mae) which assures the lender regarding the default risk while non-agency mortgages are exposed to high default risk. This means that non-agency MBS generates more returns than agency MBS due to the higher risk involved. The company's main focus is on adjustable-rate mortgages (ARM) whose rate is reset after a certain period which reduces the interest rate risk compared to fixed-rate mortgages (FRM). MFA has managed to outperform its competitors by far, even though it suffered a net decrease in market cap due to tapering. The company reported a decrease of 12% in its stock price while American Capital (NASDAQ:AGNC) and Annaly Capital (NYSE:NLY) were hit by an almost 25% decline during a 52-weeks rough patch.

Click to enlarge

Source: Y-Charts

MFA Investment Portfolio

MFA is focusing on non-agency mortgages, putting the company at default risk and increasing its operating risk. However, having a high risk is not always a bad thing as non-agency mortgages can earn higher returns compared to any other investment carried out by an mREIT. This means that an mREIT can give higher returns by managing the composition of its total investment portfolio. Approx. 44% of MFA's total portfolio is in non-agency mortgage backed securities and by looking at its share price trend (compared to its competitors), we can say that the company is earning positive returns from these non-agency investments. Furthermore, we can see that the company is investing approx. 34% in fixed rate MBS which means that a lesser part of its investment is exposed to interest rate risk. This makes MFA less risky than its competitors (due to the expected increase in US Treasury rates in the long term) AGNC and NLY which have around 96% and 77% of their investment, respectively, in fixed rate mortgages.

Source: MFA Earnings Report

We believe that MFA is exposed to lesser risk than its competitors (American Capital and Annaly Capital) even though it has a significant percentage of its investment in non-agency mortgages due to the following factors:

  1. NLY has approx. 77% of its investment in fixed mortgages as of 30th Sep 2013 while AGNC has 96% in fixed mortgages as of 31st De 2013. If the mortgage rate rises, the value of fixed mortgages will decrease irrespective of maturity duration. A higher maturity duration of fixed mortgage means a higher risk involved as small changes in the mortgage rate have an increased effect on the mortgage value as the maturity increases.
  2. We expect that US Treasury rates will rise in the long term which will lead to higher mortgage rates. For companies like AGNC and NLY it means that mortgage values will decrease in the future which, leading to a decrease in share price as it will move towards book value per share and further dividend cuts.
  3. MFA has invested in non-agency mortgages which might appear risky at first but the location of these non-agency mortgages holds great importance. 46% of the company's non-agency portfolio is in California where a home price appreciation of more than 20% is expected in the next 12 months which means that this appreciation will bring down the loan to value ratio (LTV). A higher LTV means higher risks involved while a lower LTV shows that there will be less chances of default, leading to improving credit conditions for MFA and making its non-agencies less risky.

Click to enlarge

Source: MFA 4Q 2013 Earnings Presentation

Dividend and Interest Rate Spread

MFA tried to maintain its dividend per share at around $0.20 during 2013. Even though this level of dividend appears to be low compared to its performance, we can see that the company has been paying special dividends to make its stock more attractive which allowed it to maintain a low level of dividend when other REITs were forced to decrease their dividend per share due to tapering. The stock gave special dividends of $0.50 per share during the first quarter of 2013 and $0.28 per share during the third quarter. Whereas during the same time period, AGNC decreased its dividend per share from $1.25 to $0.65 per share (which is a 48% reduction) followed by NLY which reported a $0.30 dividend per share in the fourth quarter of 2013 (a 33% decrease during the year).

Source: MFA Dividends

MFA has managed to maintain its annualized dividend yield during 2013, showing no impact of tapering on its performance, while AGNC and NLY showed a substantial decrease in their annualized dividend yield as shown below. This was caused by a decrease in earnings and book value during the year due to early tapering anticipation. MFA has an Operating Cash Flow (OCF) yield of 10.5% which shows that the company is paying almost all of its earnings from operations in dividends. Furthermore, the gap of 0.2% (between OCF yield and dividend yield) is not enough to create problems for the company so we believe that it will continue to maintain this level of dividends. However, it does indicate that MFA does not have the capacity to increase its quarterly dividends. In our calculation of the annualized dividend yield we have not considered special dividends as only MFA is giving special dividends.

Source: Yahoo Finance

Due to a combination of both agency and non-agency mortgages, MFA has a better profit margin compared to other REITs. It has reported an interest rate spread of above 2% which is almost double that of Annaly Capital and American Capital, as can be seen from graph below. This has been possible due to a high asset yield of around 4% (AGNC had an asset yield 2.59%). American Capital has reported an increase in interest rate spread to 1.56% after its asset yield increased to 2.89% during the fourth quarter whereas MFA reported an increase in interest rate spread to 2.34% after an increase of 0.21% in asset yield.

Source: MFA 4Q 2013 Earnings Presentation

Conclusion

MFA has increased the risk in its portfolio through investment in non-agency mortgages but it has countered that risk to some extent by investing around 35% in agency adjustable-rate and hybrid mortgages. MFA's strategy enabled it to operate with a higher interest rate spread when the entire REIT industry suffered greatly during the period of pre-announcement of tapering by the Fed. We are now expecting that the US Treasury rate will increase in the future, decreasing the interest rate spread even further in the entire mREIT industry. However, MFA has a lesser percentage of its investment in agency fixed rate mortgages which will prove to be a plus point for the company during times of increasing interest rates as its book value will not be affected much by an increase in mortgage rates. MFA's stock is attractive due to its consistent performance and dividends in the past. Currently the shares are being traded at a 4% discount, at $7.74, compared to its book value per share of $8.06. Moreover, special dividends make it more appealing and considering the direction in which market rates are expected to go, we recommend MFA as a buy.

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.

Additional disclosure: Equity Flux is a team of analysts. This article was written by our Basic Material and Financial analyst. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.