Why Hold MORL With A Possible Rate Hike Soon? 22.8% Yield

| About: UBS ETRACS (MORL)

Summary

The probability of a rate hike by the Federal Reserve by December 2016 has increased in the view of most market participants.

Higher interest rates are generally bad for mREITs in general and more so for a 2X leveraged mREIT instrument like MORL.

MORL has provided large total returns on a year-to-date and a year-over-year basis.

I am still a buyer of MORL based on the 22.8% effective dividend yield on a monthly compounded annual basis.

Despite Federal Reserve attempts to give assurance that any increase in rates will be very gradual, a December 2016 rate increase could cause a market tantrum and a buying opportunity.

Most observers believe that the Federal Reserve will hike its' benchmark interest rate by 0.25% before the end of 2016, most likely in December. Generally, the saying "don't fight the Fed" has been good advice for investors. There is a risk that a December 2016 rate could cause a repeat December 2015 Federal Reserve interest rate increase that caused a dramatic decline in financial markets that resulted in a great buying opportunity in, among many other securities, the UBS ETRACS Monthly Pay 2X Leveraged Mortgage REIT ETN (NYSEARCA: MORL), which closed at $9.22 on January 21, 2016.

The question is why should one buy or hold a security if there is a chance that a "buying opportunity" aka a collapse in the price, is coming soon. The answer with regard to MORL is the 22.8% dividend yield on an annualized monthly compounded basis. Another axiom in the financial markets is that securities with exceptionally high yields typically experience price depreciation which can more than offset the high yields in terms of total returns. That may not always be the case

On a year-to-date basis MORL has returned 32.3% based on a purchase at the end of 2015 at $13.28, the October 21, 2016 price of $14.58 and the dividends of $2.9937 paid this year through to October 2016. This does not include any reinvestment of dividends or any gains or losses on the reinvestment of dividends. It also does not include my projected November 2016 MORL monthly dividend of $0.0434.

My projection for the November 2016 dividend for MORL and its' essentially identical twin the UBS ETRACS Monthly Pay 2X Leveraged Mortgage REIT ETN Series B (NYSEARCA: MRRL) is $0.0434. The projection for the dividend is calculated using the contribution by component method. The Market Vectors Mortgage REIT Income ETF (NYSEARCA: MORT) is a fund that is based on the same index as MORL and MRRL. However, MORT is a fund rather than a note and thus does not employ the 2X leverage that MORL and MRRL do. MORT also pays dividends quarterly rather than monthly. As a fund the dividend is discretionary by the fund management as long as distribute the required percentage of taxable income to maintain its' investment company status. Thus, it does not lend itself to dividend projections as a ETN like MORL which must pay dividends pursuant to an indenture.

Even though MORL has increased in price, both from a year ago and from earlier this year, I am still a buyer. Mostly for the high dividend yield that still exceeds 20%. However, the current MORL price is down 10.4% from the $16.27 closing price on September 7, 2016. Most of the MORL components pay dividends quarterly. Only two of the MORL components: American Capital Agency Corp. (NASDAQ: AGNC) and ARMOUR Residential REIT, Inc. (NYSE: ARR) pay dividends monthly. The January, April, October and July "big month" MORL dividends are much larger than the "small month" dividends paid in the other months since most of the portfolio components pay quarterly, typically with ex-dates in the last month of the quarter and payment dates in the first month of the next quarter. Only three of the mREITS in the index will contribute to the November 2016 MORL dividend; AGNC, ARR and Pennymac Mortgage Investment (NYSE:PMT), whose quarterly dividend will have an ex-date in October 2016 as is shown in the table below that shows the ticker, name and weights for the index components and the dividend, ex-date and contribution for those components that will contribute to the November 2016 dividend.

The year-to-date total return on MORL of 32.3% is what could have been expected given that there have been no rate increases by the Federal Reserve in 2016. In January 2016, even those most bearish on MORL and the mREITs would have conceded that if there were no rate increases by the Federal Reserve this far into 2016, then MORL would have had a high total return at this point in time. Obviously, those who were bearish on MORL at the beginning of 2016 were expecting multiple Federal Reserve interest rate increases by now.

The outlook for MORL, the mREITs and to some extent the rest of the securities markets depends on future Federal Reserve behavior. Within the Federal Reserve and in the financial community at large there is considerable debate as to what the Federal Reserve should do next. I have said this debate can be characterized as those who want normal interest rates versus those who favor normal monetary policy.

In many of the developed countries outside the USA, the central bankers have pushed normal monetary policy far beyond what the Federal Reserve has done. Interest rates have gone into negative territory in many countries. See: More Thoughts On Negative Interest Rates. Many of those other central banks seem more aware of the dangers of using fiscal policy rather than monetary policy in terms of what it does to debt levels which are still a major problem.

The major problem with replacing monetary policy with fiscal policy to boost growth is that it will increase deficits and debt. Again, many of the same people calling for higher interest rates also bemoan the high levels of deficits and debt. Increasing government spending or reducing taxes will increase deficits and debt. Furthermore, higher interest rates also increase deficits and debt as interest expense is an important part of government expenditures. See: Long-Term Federal Budget - It Is Worse Than You Think

Generally, Janet Yellen and other Federal Reserve officials do not talk about raising rates, but rather have used the term normalization of interest rates. In the news conference following the September 2016 meeting. Janet Yellen did not use the "N" word. Rather than using the term Normalization, Yellen referred to "removal of accommodation" as a euphemism for raising interest rates. I find this very encouraging. It suggest to me that Janet Yellen and others who I would consider in the normal monetary policy camp which would call for waiting until inflationary threats are more pronounced before raising rates, may be digging in their heels against those calling for normal interest rates.

My view is that normal interest rates are not appropriate when you have very abnormal economic conditions. There has been a fundamental change world-wide this century that suggests that the rates that prevailed in the second half of the last century should not be considered as normal for the current period.

The primary change that has fundamentally changed the economy can be best described by Warren Buffett, CEO of Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B), who said, "Through the tax code, there has been class warfare waged, and my class has won," to Business Wire CEO Cathy Baron Tamraz at a luncheon in honor of the company's 50th anniversary. "It's been a rout."

One does not have to be a Keynesian to see that shifts in income to those with lower marginal propensities to consume will cause an increase in savings and a decline in consumer spending. The wealthy clearly have lower marginal propensities to consume. As I explained in a Seeking Alpha article "A Depression With Benefits: The Macro Case For mREITs":

Shifting income to the rich by taxing dividends, capital gains, inheritances and corporate profits much less than the tax rates on wages also tends to make more funds available for investment since when the investment is taxed relatively less, more funds are made available for the investment. That would also put downward pressure on interest rates.

The forces driving inequality through the class warfare that Warren Buffett points to are cumulative. It is the compounding effect of shift away from taxes on capital income such as dividends, capital gains and inheritances each year as the rich get proverbially richer which is the prime generator of inequality.

This cumulative shift of wealth from the middle class to the very wealthy has profound impacts on the economy and securities markets. It creates a cycle where initially the wealthy pour significant amounts into investments they perceive to be safe. This can first cause an increase in economic activity. In 2005 many considered mortgage-backed securities with adjustable interest rates to be essentially risk-free. This was especially true for those rated AAA by Moody's and S&P. This resulted in overinvestment in the real estate sector. The middle class eventually could not service the mortgage debt on their homes nor could they buy enough goods at shopping centers and department stores to generate enough funds to prevent many residential and commercial mortgages from defaulting.

The central bankers seem to be aware that today's situation is not normal. The negative interest rates in many countries engineered by central banks is evidence of that. The Federal Reserve has not resorted to negative rates and actually raised short-term rates by 25 basis points in December 2015.

The December 2015 rate increase caused a dramatic decline in financial markets that resulted in a great buying opportunity in, among many other securities, MORL that closed at $9.22 on January 21, 2016. The question for MORL investors is will the Federal Reserve cause a repeat of the December 2015 debacle or have they learned their lesson?

The economy is growing at a very modest rate around 2% and inflation is still well contained. This modest growth has only been possible because of the Federal Reserve's low interest policy. There are surely some households and businesses that are barely hanging on by their fingernails. They would possibly be unable to meet their financial obligations if the interest rates on their adjustable rate loans were increased by another 25 basis points.

Despite the risk to the economy that higher rates would entail, there are members of the Federal Reserve Open Market Committee who seem to favor rate increases. There are some legitimate concerns related to the low interest rate policy. Investment behavior is impacted by the low interest rate policy in ways that could be problematic.

An analogy for the decisions facing the Federal Reserve could be that of a ship that has been damaged by a storm and is leaking. Only by running the engines and the bilge pumps full out has Captain Yellen been able to keep the ship afloat and maintain a speed of only two knots. She convenes a meeting of the ship's officers. Some of the officers urge returning to normal operation of the ship's engines and the bilge pumps. They argue that if there were to be another storm, they would not be able increase engine speed anymore. Some say that a while ago when the ship was higher in the water, they should have reduced the speed and use of the bilge pumps. Saner officers point out that had they not kept the engines going at maximum they would now be under water and that now is a particularly bad time to reduce speed and pumping since there are many sharks circling the ship.

As long as there is a much greater supply of loanable funds than the demand for them in the risk-free credit market, risk-free and near-risk-free interest rates should remain low. Attempts by the Federal Reserve to push risk-free rates higher than what supply and demand would otherwise indicate might only result in weaker economic activity. Lower rates are by far the best environment for UBS ETRACS Monthly Pay 2xLeveraged ETNs such as MORL and MRRL.

One could argue that my view on interest rates has prevailed for the last three years and mREITs have declined in price over much of that period. Some of the decline is due to actions taken by some of the mREITs' managers, which have been inept or worse. However, most mREITs have gone from trading at premium to book value to deep discounts to book value. While there are risks and problems associated with mREITs and MORL, it is the enormous yields, which I think will ultimately result in mREITs and MORL providing substantial returns as long as interest rates remain subdued.

Even after the rebound in MORL and MRRL from the January 2016 lows, the yields are still relatively large. For the three months ending November 2016, the total projected dividends are $0.755. The annualized dividends would be $3.021. This is a 21.1% simple annualized yield with MORL priced at $14.58. On a monthly-compounded basis, the effective annualized yield is 22.8%.

Aside from the fact that with a yield around 20%, even without reinvesting or compounding you get back your initial investment in only five years and still have your original investment shares intact, if someone thought that over the next five years' interest rates would remain relatively stable, and thus, MORL would continue to yield 22.8% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $279,292 in five years. More interestingly, for those investing for future income, the income from the initial $100,000 would increase from the $22,800 initial annual rate to $63,867 annually.

Holdings of MORL and MRRL Prices 10-19-2016

Name

Ticker

Weight

Price

ex-div

dividend

frequency

contribution

Annaly Capital Management Inc

NLY

14.16

American Capital Agency Corp

AGNC

8.94

19.48

10/272016

0.18

m

0.02401

Starwood Property Trust Inc

STWD

6.93

Blackstone Mortgage Trust Inc

BXMT

5.15

New Residential Investment Corp

NRZ

5.08

Two Harbors Investment Corp

TWO

4.86

Chimera Investment Corp

CIM

4.83

Colony Financial Inc

CLNY

4.74

MFA Financial Inc

MFA

4.44

CYS Investments Inc

CYS

4.44

Invesco Mortgage Capital Inc

IVR

4.32

Pennymac Portgage Investment

PMT

3.59

14.93

10/5/2016

0.47

q

Apollo Commercial Real Estat

ARI

3.4

ARMOUR Residential REIT Inc

ARR

2.87

22.36

10/12/2016

0.22

m

0.00821

Capstead Mortgage Corp

CMO

2.78

Hannon Armstrong Sustainable Infrastructure Capital Inc

HASI

2.77

21.6

10/3/2016

0.3

q

0.01118

American Capital Mortgage Investment Corp

MTGE

2.74

New York Mortgage Trust Inc

NYMT

2.53

Redwood Trust Inc

RWT

2.33

Istar Inc

STAR

1.66

Anworth Mortgage Asset Corp

ANH

1.62

Ladder Capital Corp

LADR

1.62

Western Asset Mortgage Capital Corp

WMC

1.6

AG Mortgage Investment Trust Inc

MITT

1.33

Resource Capital Corp

RSO

1.25

Click to enlarge

Disclosure: I am/we are long MORL, AGNC, ARR, MRRL.

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.