Opportunity In The 8.6% Yield: Something For Nothing

| About: New York (NYMT)

Summary

The mortgage REIT sector exhibits at least a few opportunities where prices become inefficient.

So far this year, I’ve seen a few opportunities come up in the preferred shares of larger mortgage REITs. Opportunity disappeared hours or weeks after publication (varies).

NYMTO is currently superior in every metric except one, and that one can be easily misunderstood.

NYMTO offers better call protection, a larger discount to call value, and a larger coupon payment.

This trade was viable at the closing prices on Friday and at the “last executed” prices when I wrote this on Monday morning. Beware liquidity. No market orders.

It is rare in the financial markets to get something for nothing. This is one of those rare opportunities where, due to poor liquidity and a lack of analyst coverage, market prices can diverge on very similar securities. In this case I am writing about NYMTO and NYMTP. These are the two preferred shares for New York Mortgage Trust (NASDAQ:NYMT). This kind of divergence in pricing happens occasionally.

I have seen this happen with other mortgage rates including in AGNC Investment Corporation (NASDAQ:AGNC) and ARMOUR Residential REIT (NYSE:ARR). More recently I saw it occur with Annaly Capital Management (NYSE:NLY). When even the large mortgage REITs can have this disconnection occurring in their preferred stock, it should be no surprise that New York Mortgage Trust would be ripe for the same issue.

For your convenience:

AGNC's Preferred Stock Comparison

ARR's Preferred Stock Comparison

NLY's Preferred Stock Comparison

In each of those 3 cases, within a few weeks of writing about the opportunity it disappeared. In some cases the problem was resolved far quicker, but in each case the issue was solved or substantially reduced.

Pricing information

At the most recent prices NYTMP offers a weaker stripped yield, a weaker current yield, less call protection, and a smaller discount to face value (face value is treated as the call price of $25). The only area where NYMTP could be considered superior is in the "yield to call." This is a really stupid scenario.

The yield to call is higher on New York Mortgage Trust because it has less call protection and both securities trade at about the same price. Think about that for a moment. The only way NYMTP is superior to NYMTO is if an investor was buying it, hoping for the call to happen, and believing that it will happen as soon as it can happen. In a nutshell, they are banking on a $2 capital gain from a theory that the shares will be called immediately. Under any other circumstance they have failed in their due diligence by selecting NYMTP over NYMTO when shares of NYMTO are slightly cheaper.

Below is some of the data on NYMTP and NYMTO from my latest article for subscribers:

Click to enlarge

The high and low prices were based on price movements from the end of Q2 in 2015 to the end of Q2 in 2016. That period included periods of strong optimism and periods of fierce negativity. Both shares fell onto support at almost the exact same level, but that level was only reached during what appeared to be a liquidity crisis as extremely hard selling hammered away at values.

The value on the right, "Worst Cash to Call," is an estimate of the total amount of cash return the investor would achieve (beyond a return of their purchase price) if the securities were called as soon as the call protection ended. The idea that NYMTP has a better "yield to call" is stupid. A security trading at $24.50 that is callable tomorrow would have a dramatically better yield to call, even if it was never going to be called. I prefer using "Worst Cash to Call" rather than yield to call because it eliminates these problems. If the security trades over par value, then this value can go negative just like the yield call too would become negative. However, it avoids the problem of rapidly accounting for a hypothetical gain from the security suddenly being called.

How Does This Happen?

There are two ways this can happen. One is simply that humans are doing the trading and have imperfect information. Since their research is limited by the tools and time they have available, they are stuck with the challenge of the "rational man." The rational man problem in economic theory refers to a human's inability to have complete and perfect information prior to acting (contrary to most economic theories). Consequently the man must choose an option that has an attractive risk-to-return profile, even though it may not be optimal. This theory says investors just didn't notice the disconnection.

All else equal a higher yield to call is better. However, all else is not equal. I cannot stress that enough. When call protection is materially different, things are not equal. If NYMTO simply forfeited about a year of the call protection, it would have a higher yield to call than NYMTP. This is clearly the case because it trades at a lower price and has a larger dividend payment each quarter. If the call dates were the same, a security that costs less and pays more must have the better yield to call.

Making a play

I noticed this disconnection had occurred again when I was looking over the pricing data on Friday. When I saw the opportunity, I posted it for my subscribers and then I took a very small position in NYMTO. My goal is not to hold the shares for the long term. I only intend to hold this position until prices adjust. That is it. It is important to me as an analyst to ensure readers understand my intention. I found the disconnect, much like I found other disconnects for other preferred shares, and then I told the people who pay me (subscribers), followed by taking a piece of the trade for myself since it was still there. I intend to take the capital gain. I do not expect to hold these long enough to reap a single dividend.

I see a material difference in the risk-to-return profiles across these two preferred shares. I expect that difference to disappear when investors become aware of it. Consequently I see an opportunity to turn a profit. I say this clearly to ensure that investors cannot miss the disclosure. My integrity is more important than the profit on a position that is significantly less than 1% of my portfolio.

How do investors get something for free?

(No tax advice or financial advice, just my thoughts:)

The simple solution is for the tax-exempt investor or the investor in a position of an unrealized loss, to sell shares of NYMTP and replace them with shares of NYMTO. Because of poor liquidity, investors need to check the bid-ask spreads before placing any orders. As of the closing prices on Friday this trade was viable. As of the prices that were executed on Monday morning, this trade was still viable. I cannot feasibly state whether this trade will be viable an hour after publication or even at the moment of publication. I can only state that it was possible at the prices that executed this morning.

I believe the price on a share of NYMTO, in an efficient market, should be consistently higher than the price on a share of NYMTP. This is logically the case because both securities are claims on the same company. Further NYTMO offers a higher original coupon rate. Instead of 7.75% on NYMTP, the rate is 7.88%. Because it carries a higher coupon rate, whenever the shares trade at a similar price, they offer a higher yield. The difference is more pronounced when NYMTP becomes more expensive.

Further, because the call protection is extended for a longer period of time, it is inherently superior to call protection that ends earlier. While some investors may dream about buying shares at a discount to the call value and having them called the next day, those are merely dreams. They are not investments. They are not a viable strategy for making money. They are nothing beyond ill-informed hope. If the investment environment were to reach the point where NYMT would want to call the first series of stock (that means NYMTP), the second series of stock (referring to NYMTO) would almost certainly trade at a premium to par value in the free market.

Data to Help With Trades

I believe NYMTO should trade at a premium of $.30 to $.50 relative to NYMTP. I expect to see shares of NYMTO move higher, and I intend to capitalize on that trade.

Beware that liquidity comes and goes. This trade might not be viable at one point and then could open up again 10 minutes later. Check live bid-ask spreads.

I'm making this as a short-term play because I'm not as thrilled by NYMT over the long term. I criticized NYMTP specifically when it was trading at an 8.3% yield. It declined to 8.44%, but NYMTO offers 8.6%. I think 8.6% on NYMTO is materially more attractive than 8.3% was on NYMTP.

I have investments in several preferred shares that I'm very comfortable holding for a long time period. This is one of the more volatile preferred shares. My other preferred shares are AGNCB, AGNCP, NLY-D and NLY-E.

If you want to get my best research and early access to some of my REIT articles, consider joining The Mortgage REIT Forum. For the cost of one lunch per month, you can get access to the research I'm using for managing my own investments. Subscribers also receive real time alerts when I see the liquidity failing on individual securities. I informed subscribers of this trade on Friday before investing in it and I called it out again over the weekend.

Disclosure: I am/we are long NYMTO, AGNCB, AGNCP, NLY-D, NLY-E.

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. Tipranks: Assign no ratings. This is about preferred stock.