ARM mREITs: Take The Discount On These Low Risk Funds

by: Thomas C.

The good news keeps rolling in - house prices are up, mortgage rates are rising, the Fed is murmuring about the end to QE, but our favorite mortgage REIT funds are suffering severe declines. Amid the panic, two funds with low-risk portfolios have been irrationally sold off.

Hatteras Financial Corp. (NYSE:HTS) and Capstead Mortgage Corporation (NYSE:CMO) invest substantially all of their leveraged shareholder capital in government guaranteed adjustable rate mortgage securities. Not only do they have no risk of loss due to default, but since interest rates on the underlying mortgages move up and down with the market, they have no interest rate risk. Yet these funds have suffered price declines as if they were at risk of portfolio losses as mortgage rates rise. This is a great opportunity for savvy mortgage REIT investors to buy dollars for $0.90.

Table 1 presents fund profiles, share price as of May 29, the percent price decline during May 2013, and the discount to the March 31 book value (the most recent financial statement date). CMO and HTS are selling at discounts comparable to funds at-risk for portfolio losses, but they may be turning around. Yesterday (May 29) CMO and HTS share prices closed well off their lows and posted small gains.

Table 2 presents recent quarterly book value per share, comprehensive EPS, and dividends. For the last nine months CMO has funded its dividend with earnings and gained in book value. HTS performed nearly as well, posting an immaterial $0.01 decline in book value. The declining earnings per share and book value of the other funds portend a probable dividend reduction and more share price volatility.

CMO is in the process of redeeming its relatively expensive Series A and B preferred stock and replacing it with a new 7.5% Series E issue that will reduce expenses by an estimated $0.015 - $0.025 per share per quarter resulting in increased yield to common shareholders. CMO has posted impressive results for the trailing three quarters and I see no reason not to expect even better results going forward.

In the near term, I expect the irrational discount of HTS and CMO to narrow and possibly turn into a small premium, as investors come to understand the lower risk of ARM mortgage REITs compared to conventional fixed rate agency funds. Right now we have an opportunity to buy these funds at a discount and take advantage of their unique intrinsic value.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.