Thoughts On A Handful Of mREITs And The State Of The Industry (Week 36)

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

Summary

The yield curve steepened slightly.

The yield spread on MBS to LIBOR swaps widened which should create losses for most mREITs.

While the flat yield curve is pretty terrible for investing the wider spreads on MBS to swaps is attractive for entering positions.

The case for using the 30YR FNMA 3.0 and 3.5 with hedges through swaps running 3 years to 5 years looks solid using data from Thursday 06/16/2016.

I’m ballparking the spread on new positions in the 30YR FNMA 3.5 hedged with an even mix of 3 year and 4 year swaps as 1.83%.

Welcome to week 36.

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

(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

Spreads

Remember that the simplest explanation of the mortgage REIT is to say that they have a leveraged portfolio of long term bonds financed with short term rates. The first starting point should be reading the steepness of the yield curve, so each week starts with this reading.

7 to 1

10 to 2

Q4 2014

1.72

1.5

Q1 2015

1.45

1.38

Q2 2015

1.79

1.71

Q3 2015

1.42

1.42

Q4 2015

1.44

1.21

1/8/2016

1.27

1.19

1/15/2016

1.3

1.18

1/22/2016

1.34

1.19

1/29/2016

1.2

1.18

2/5/2016

1.03

1.12

2/12/2016

0.99

1.03

2/19/2016

1

1

2/26/2016

0.95

0.96

3/4/2016

1.02

1

3/11/2016

1.09

1.01

3/18/2016

1.04

1.04

3/24/2016

1.07

1.02

4/1/2016

0.94

1.03

4/8/2016

0.93

1.02

4/15/2016

0.99

1.02

4/22/2016

1.11

1.05

4/29/2016

1.04

1.06

5/6/2016

1.04

1.05

5/13/2016

0.96

0.95

5/20/2016

0.98

0.96

5/27/2016

0.99

0.95

6/3/2016

0.9

0.93

6/10/2016

0.87

0.91

6/17/2016

0.9

0.92

Click to enlarge

State of the Industry

I continue to believe that non-agency RMBS are offering some fairly attractive returns based on an assessment of rates remaining lower for longer and leading to refinancing activity on non-agency MBS. I would expect a portfolio emphasizing the 30YR FNMA 3.5 at 105.05 (latest price) hedged with an even mix of 3 year swaps and 4 year swaps to perform quite well moving forward. The same can be said for running the 30YR FNMA 3.0 at 102.97 (latest price) and hedged with a portfolio split between the 4 year and 5 year swaps.

Higher coupon MBS could be hedged by shorter swaps due to the convexity on the yield curve but I don't like the refinancing risk on higher coupon MBS.

The spread between MBS and LIBOR swaps is quite attractive despite a flat yield curve. The way to capitalize on that spread is to boost leverage and emphasize hedging with shorter duration swaps. Using long duration swaps would reduce the net interest expense but expose the mortgage REIT to larger book value losses if the yield curve flattens further. Based on the yield curves in Japan and Germany, I don't see a reason to believe the yield curve will not compress further.

To emphasize the MBS to LIBOR swap spread I would suggest emphasizing REITs with portfolios that are willing to use a material amount of leverage and emphasize hedging the shorter part of the yield curve and using lower coupon MBS.

Example

I'm running some estimates using values from 06/16/2016. The 30YR FNMA 3.5 was running 105.14% of par value. Assuming a flat CPR rate of 8% (this oversimplifies because it treats CPR as a flat function), the expected annualized yield would run around 2.76%. The importance of using the 30YR FNMA 3.5 rather than the 4.0 is to reduce the risk of dramatically increased prepayments if domestic rates fall lower.

Hedging the position with a combination of the 3 year swap at .889% and the 4 year swap at .965% would create an effective cost of funds at .927% assuming the receive rate on the swaps offset the rate paid on the repo agreements. The resulting spread of roughly 1.83% looks fairly solid. Even at 6x leverage the spread income would be 11%. Note that this excludes both operating costs and the yield on the assets financed with equity.

Conclusion

The widening of spreads between RMBS and LIBOR swaps is becoming quite attractive despite the flattening of the yield curve. A flat yield curve is terrible for mortgage REITs but a spread between MBS and swaps produces some attractive opportunities.

I like the use of non-agency RMBS as a way to seek a little additional yield and as a further hedge against a shift in the spreads. If RMBS rates were to continue falling substantially lower to the point where it could trigger a material increase in the CPR on the 30YR FNMA 3.5 it should also drive housing prices higher to the point where non-agency MBS could be refinanced into new loans. When non-agency MBS are held at a substantial discount to par value the increase in refinancing on those loans would be a positive.

My current position is long in common of ARR. I might sell it if the right price was available (it isn't currently), and I might buy another mortgage REIT or buy preferred shares in any of the mREITs.

Disclosure: I am/we are long ARR, PREFERRED SHARES OF 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. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. 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.