Investing In Pancakes

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Includes: AGNC, AI, AMTG, ANH, ARR, BXMT, CHMI, CIM, CMO, CYS, DX, EARN, JMI, MFA, MORT, MTGE, NLY, NRZ, NYMT, ORC, REM, SPY, STWD, TWO, WMC, ZFC
by: ColoradoWealthManagementFund

Summary

The mREIT sector is still heading towards pancake status.

The flattening of the yield curve delivers thinner net interest spreads over time.

The market tends to overvalue mREITs when the yield curve is flat and undervalue them when the yield curve is steep.

On March 23rd, 2016, the market took a minor hit from the Federal Reserve. Equity markets rolled less than 1%, but the mREIT sector saw some larger moves and bond yields took some material movements for a single day. Share prices across the sector will look significantly weaker on some screening tools or applications as a result of some mREITs going ex-dividend for the quarter on the date. However, there were other factors investors should know about.

The mREITs (and two ETFs)

The table is demonstrated below:

(NYSE:NLY)

Annaly Capital Management

(NASDAQ:AGNC)

American Capital Agency Corp

(NYSE:ARR)

ARMOUR Residential REIT

(NYSE:CMO)

Capstead Mortgage Corporation

(NYSE:CYS)

CYS Investments

(NYSE:DX)

Dynex Capital

(NYSE:JMI)

Javelin Mortgage Investment

(NASDAQ:NYMT)

New York Mortgage Trust

(NYSE:ORC)

Orchid Island Capital

(NYSE:TWO)

Two Harbors Investment Corp

(NYSE:WMC)

Western Asset Mortgage Capital Corp.

(NYSE:MFA)

MFA Financial

(NYSE:EARN)

Ellington Residential Mortgage REIT

(NYSE:AI)

Arlington Asset Investment Corporation

(NYSE:ZFC)

ZAIS Financial

(NYSE:AMTG)

Apollo Residential Mortgage

(NYSE:ANH)

Anworth Mortgage Asset Corporation

(NASDAQ:MTGE)

American Capital Mortgage Investment

(NYSE:CHMI)

Cherry Hill Mortgage Investment

(NYSE:STWD)

Starwood Property Trust

(NYSE:BXMT)

Blackstone Mortgage Trust

(NYSE:CIM)

Chimera Investment Corporation

(NYSE:NRZ)

New Residential Investment Corp.

(NYSEARCA:REM)

iShares Mortgage Real Estate Capped ETF

(NYSEARCA:MORT)

Market Vectors Mortgage REIT Income ETF

Click to enlarge

Ex-Dividend Movement

REM fell from over $9.82 to $9.39 with a dividend of $.27. After adjusting for the dividend the movement is almost 2%. That is large enough to indicate some backlash on mREITs.

Broad equity markets also fell with the S&P 500 (NYSEARCA:SPY) down .68%. That isn't large enough to be significant given the size of movements we've size of movements we've seen over the winter. It does appear to speak to the market having a slightly weaker appetite for risk though. Remember that mREITs and other equity investments should have very little in common.

The trend for equity markets and several of the agency mREITs has been a disregard for risk. Regarding the agency mREITs, I believe this has resulted in price levels that are widely too high relative to the potential for returns.

Time for Pancakes

Pancakes are the thing I really want to talk about. Later this year we may have to end up talking about paper, because the yield curve is becoming very flat and the net interest spreads should get flattened out over the next few years absent any accounting techniques used to prop them up.

Click to enlarge

Since late February there was a slight steepening of the yield curve, but the steepening decreased today (March 23rd).

A few weeks ago I did a fairly extensive piece demonstrating how the market irrationally overvalues mREITs while the yield curve is flattening and undervalues them when the yield curve is steeper. Book value is an extremely important part of analysis, but in assessing the entire sector it is important to look at the level of interest spreads that can be reasonably created.

In general a steepening yield curve is hard on book values since mREITs usually have positive duration. Despite the immediate damage to book value, it is a steep curve that allows the mREITs to create a strong net interest spread. When yield curves are steepening, book values often take a hit and share prices can get hammered pretty hard. Now that the yield curve is flattening and the book value losses should be more tame (not for ARR, due to their hedge choices), the market is shrinking discounts again.

Some People Might Buy Anything

How much would you be willing to spend on shares of an mREIT if the dividend was nothing? That may seem pretty absurd, but when the yield curve inverts the ability of an mREIT to generate net interest income is severely compromised. The MBS may still offer stronger OAS (option adjusted spreads) than the cost of funds, but investors shouldn't expect that to create a strong dividend. Would a yield of 3% to 6% on book value still be impressive? In such a situation an mREIT can either hedge up and lock in that scenario or drop hedges and hope for short term rates to fall. That strategy makes more sense when short term rates are running 3% to 6% than when the 1 year rate remains under .65%. Short term rates don't have very far to fall, and I'm not convinced that they will fall as opposed to rising. Unemployment is still looking good and equity prices are headed higher. Of course the Federal Reserve's dual mandate is unemployment and inflation, but it seems they watch equity prices and ignore the TIPS to treasury spread. I'm not predicting an April increase, but I don't think a cut is about to happen either.

Of course, it is possible for mREITs to pay out book value to sustain their dividends and there are ways assets and hedges could be set up to provide the appearance of stronger margins. Neither of those stunts will impress me much.

Conclusion

The yield curve flattened again today and mREITs finally saw some retreat in their share prices. When I'm assessing mREITs, I'm looking at the fundamentals. The fundamentals do not justify these prices, unless you are willing to buy book value regardless of the dividend yield it can support.

To be bullish I'd need to see a steeper yield curve or larger discounts to book value. I do think there may still be some opportunities for attractive returns. The majority of those opportunities are more likely to be present on the short side of the equation than the long side. I'll keep my options open as I may find a solid value at any point.

The mREITs I've recently looked into and know I won't be buying in the near future are ORC, AGNC, and ARR. I've looked into NYMT and the current price is within the reasonable range (no attractive long or short options), but the share price can swing quickly.

There is one attractive thing worth mentioning. The LIBOR rates being lower than treasury rates for several maturities looks favorable for the cost of funds.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ANY OF THEM EXCEPT ORC, ARR, OR AGNC over 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: 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.