Thoughts On A Handful Of mREITs And The State Of The Industry (Week 56)

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

Summary

The last few weeks have seen yields move higher and the curve become substantially cheaper.

Some analysts are becoming more bearish on mortgage REITs due to the potential for damage to book values.

Dividends get more sustainable when the yield curve gets steeper.

A steeper yield curve is much more attractive for the fundamentals of a mortgage REIT.

Welcome to week 56.

This has been a great time for picking individual mortgage REITs. I've seen a couple of my positions soar significantly higher over the last week even though gains were not spread even close to evenly throughout the sector. There have been a couple of important factors in picking the right mortgage REITs. One was being able to estimate discounts to book value and another was not jumping into the path of Treasury bears as they drove prices lower and yields higher. Investors choosing to bet on yields suddenly reversing course were in for some severe punishment.

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 (bought by ARI)

(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

Spreads climbed rapidly back towards the level they were holding at the end of 2015. We are not there exactly, but very close with a little more emphasis on a larger 10 to 2. The 7 to 1 spread was a little smaller now than it was at the end of last year, but overall the steepness looks pretty similar.

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

6/24/2016

0.87

0.93

7/1/2016

0.82

0.87

7/8/2016

0.71

0.76

7/15/2016

0.9

0.89

7/22/2016

0.85

0.86

7/29/2016

0.79

0.79

8/5/2016

0.85

0.87

8/12/2016

0.8

0.8

8/19/2016

0.84

0.82

8/26/2016

0.87

0.78

9/2/2016

0.88

0.8

9/9/2016

0.93

0.88

9/16/2016

0.9

0.93

9/23/2016

0.84

0.85

9/30/2016

0.83

0.83

10/7/2016

0.89

0.9

10/14/2016

0.92

0.96

10/21/2016

0.87

0.9

10/28/2016

0.97

1

11/4/2016

0.93

0.99

11/10/2016

1.2

1.23

11/18/2016

1.37

1.27

Source: Data from Treasury Website

Click to enlarge

Things I See

As an analyst, I see the positive implications of a steeper yield curve, but I also see several other factors creeping up. The performance of non-agency RMBS should suffer a bit and housing values should stall out due to higher interest rates making mortgages less affordable for middle class families. When the non-agency RMBS were legacy positions that had a fair market value around 80% (give or take 5%) of par value, any prepayment on that pool would be a positive. Who doesn't want to buy a debt for $80 and get paid $100?

On the other hand, mortgage REITs that were not specifically hedging against a steeper yield curve or using derivatives like IO strips (interest-only strips) could see some severe book damage. If a mortgage REIT was only hedging against the first 5 to 6 years on the curve, their hedges are unlikely to provide gains large enough to offset the losses on the agency RMBS positions.

Better Dividends

For mortgage REITs to earn a huge dividend yield, they benefit substantially from a steeper yield curve. They want to maximize the difference between their yield on assets and the cost of funds. A steeper yield curve will reduce prepayments coming in on the agency RMBS which means the REIT can record a lower amortization expense.

While an mREIT would often want prepayments on their legacy non-agency RMBS, it is pretty rare for them to actually want prepayments on the agency RMBS. The agency RMBS usually trade above par value, so for each $100 received, the mREIT will lose a couple of bucks to needing to buy a new security when they reinvest.

Bearish on OAKS

The one mortgage REIT I would single out here for their unsustainable dividend is Five Oaks (NYSE:OAKS). I think investors completely misunderstood their recent dividend event and don't realize that the company is struggling with operating expenses that are far too high. I'm very bearish on OAKS and may enter positions that reflect that view.

Positions

My current positions (all long) are:

DX, NLY, ANH, CMO, SLD, BMNM, RSO, NLY-D, AGNCB, CMO-E, RSO-B.

The Mortgage REIT Forum is a new subscription research platform. It is nearing 100 subscribers. The first 100 subscribers will be able to lock in their subscription rates at only $240/year. After the service gets past 100 subscribers, there will be a price increase for new subscribers only. All existing subscribers will be grandfathered in at the current rate. The service includes coverage on about a weekly basis for preferred shares of almost every mortgage REIT and recalculations of current book values and discounts for common shares of a small handful of mREITs. It also includes advance previews of some of my public articles on mREITs. A week ago, I published on the opportunity to buy RSO. At the end of the week, I published another piece on the opportunity to short OAKS.

Disclosure: I am/we are long DX, NLY, ANH, CMO, SLD, BMNM, RSO, NLY-D, AGNCB, CMO-E, RSO-B.

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 short ratings to OAKS.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.