Capstead Mortgage Corporation: The Adjustable Rate Portfolio

| About: Capstead Mortgage (CMO)

Summary

CMO uses a substantial position in adjustable rate mortgages.

The mREIT was trading at a smaller discount than peers when the third quarter began, but shares have been doing poorly since.

CMO labels their swaps as cash flow hedges and created an income statement that resembles very high quality Core EPS.

There are two hedging positions that are not wrapped into the income statement, but I don’t see the costs as being a substantial factor.

The biggest risk factor for CMO is continued high levels of amortization due to refinancing by home owners.

Capstead Mortgage Corporation (NYSE:CMO) is a REIT that recently came on my radar. The mREIT is now trading at a substantial discount to book value that puts the price to book in relatively the same league as peers. As I was working on my goals and plans for 2016, one of the things I decided I wanted to increase was my coverage on mREITs and triple net lease REITs. Of course, CMO is one of the former. As a mortgage REIT, they are primarily invested in agency ARMs (adjustable rate mortgages).

The CMO Strategy

When it comes to agency ARMs, I find myself somewhat conflicted. As a general rule, I don't love adjustable rate mortgages because I think it is generally a poor way of dividing up risk. Home buyers understand dramatically less about the interest rate environment than the banks or the mortgage REITs, and they are less likely to effectively hedge against changes in rates. I'm already long Dynex Capital (NYSE:DX) because I liked their internal management structure and heavy exposure to triple A and agency CMBS. However, they own a material amount of agency ARMs as well, which means the agency ARM investment type is already included in my portfolio.

The CMO Price Drop

Capstead Mortgage Corporation was trading at a material premium to peers prior to the start of the third quarter. Since the third quarter began, they have dramatically underperformed the sector, which puts many shareholders into a hard position. They don't want to sell their shares and eat the loss, but they may also be worried about the sustainability of the dividend.

Simpler Than Core EPS

For many quarters there is no listed value for "Core EPS" in the presentations provided by CMO. That seems weird at first, until you recognize that they are designating all of their swaps as cash flow hedges and keeping the changes in fair value out of the income statement. Essentially, what they report under GAAP is akin to what most companies would report for Core EPS. There are a few companies that create more interesting definitions of Core EPS, but this simple method works very well for CMO. Since they have almost zero hedges that flow outside these calculations, the result is what I call "High Quality Core EPS". The most relevant comparison I can find is CYS Investments (NYSE:CYS), and investors may know that I have long considered CYS to provide the highest-quality Core EPS in the industry.

Their income figures are demonstrated better in the presentation than in their quarterly filings:

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The breakdown of these costs is inherently the same as reconciling from gross interest income to Core EPS. Personally, I believe when non-GAAP figures are used, it is substantially more helpful for the company to offer reconciliation from gross revenues rather than from net income. Doing it in a "side by side" manner would make it substantially easier for both retail investors and analysts to quickly assess the metrics. In this case, no reconciliation is needed because net income for CMO functions like Core EPS.

There is one exception to the rule of hedging costs being fully wrapped into the income statement in this scenario. There were two forward starting swaps held by CMO. The first is presented in the following image:

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The forward starting swap has a notional of $600,000 (in thousands) and a rate of .83. Because this is less than a tenth of the swap value and the rate is higher, but not exceptionally higher, I don't view this is a material factor. The "per share" impact of the swap on the income statement would be fairly minor.

The other forward starting swap position is a combination of a few positions that together have a weighted average rate of 4.09% and 20-year payment terms. These swaps become active in dates ranging from October 2015 through September 2016 and hedge the payments due on some long-term debt. The positions were opened up back in 2010. Normally this would sound like a problem due to the high rate on those swaps, but the combined notional value is only $100,000 (again data in thousands). While a hundred million may seem like a big deal, the company has total liabilities of almost $13 billion. The portion of liabilities covered by this swap is less than 1%. The gross payment on the swap would be just over $1 million per quarter ($4.09 million/year). After we adjust for the net payment coming in on the swap, the result is around $750,000 to $850,000 per quarter. The precise value will depend upon the short-term LIBOR rates over each quarter.

This comes out to less than one penny per share. Compared to the average amount of hedging costs mREITs are passing through book value, this is fairly minor. To be specific, the middle of my range would make the cost $.0084 or 84% of a penny per share.

Why is CMO Getting So Cheap?

I believe the major reason for shares of CMO to be selling off is because investors are very scared of another dividend cut coming in 2016. The mREIT had to cut their dividend lately amid an environment that was very harsh on adjustable rate mortgages. The dividend has already been sustained for the fourth quarter at $.26.

Going into the fourth quarter, the REIT had only generated $.72 in income on the year but their dividend distributions so far were $.88.

If CMO Hedged Through Book

If CMO were using the techniques that many other mREITs are using to enhance Core EPS, it would have allowed them to write a higher value onto the income statement, though the underlying portfolio would not have changed. In such a situation, I don't think their share price would be underperforming the sector. This is a case where high-quality Core EPS that incorporates more of the full costs of running and hedging an mREIT is resulting in investors being more concerned about the potential for a dividend cut. I don't see a real difference in value between hedging through book and running the costs through the income statement, so I'm just looking to find which mREITs will offer me the best bargain.

The Biggest Risk Factor

I'm not applying a buy/sell rating to CMO yet, but I do want to highlight the biggest risk factor for CMO going into 2016.

With the short-term rates rising, it would appear that both their yield on assets and their cost of funds should be increasing over time. Ideally this would provide a steady net interest spread, but there are a couple of important complications.

They will need to finance the portfolio at the repo rates, which will generally be based on shorter term rates than the 1-year LIBOR rates that the mortgages use for resetting. If the difference between the very short rates and the 1-year rates decline, it would hurt their net interest income. Note that part of their exposure to these repo rates is already being hedged through interest rate swaps, so I don't expect this to become a huge factor unless the 1- to 3-month rate increases to match the 1-year rate.

Another problem they face is the challenge of amortization. The last couple days have been fiercely negative for their forward earnings (in my opinion). There has been a material decline in the 10-year treasury rates and the yields on fixed rate MBS declined materially. I believe the originators of mortgages will want to make a big push to refinance home owners into new fixed rate mortgages or new adjustable rate mortgages with a temporary lock (say 5 years) on the initial fixed rate. The biggest threat to the asset yield for CMO right now is high levels of amortization.

This risk of amortization expenses on adjustable rate mortgages is also a substantial risk factor for Dynex Capital moving forward. The benefit for Dynex Capital is that their portfolio also includes substantial positions in CMBS that include protections against prepayment. As a result, their overall prepayment risk is controlled.

Disclosure: I am/we are long DX.

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: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.