Investors Should Put Nuveen Mortgage Opportunity Term Fund On Their Watch List

| About: Nuveen Mortgage (JLS)
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The purpose of this article is to highlight a potential buying opportunity in Nuveen Mortgage Opportunity Term Trust Common Fund (NYSE:JLS). Highlighted on Morningstar's website, Nuveen Mortgage Opportunity Term Trust Common Fund seeks total return through opportunistic investments in mortgage-backed securities (MBS).

JLS was brought to my attention when I was reviewing a comparable closed end fund (PIMCO's Global Government Common Fund (NYSE:RCS) over the weekend and once I reviewed the fund, I saw a potential buying opportunity that I wanted to highlight. Key finding: the fund has strayed far from its 3 year average discount to net asset value, which is what I will be addressing below (with some other data points about JLS).

Quote Snapshot

Market Cap: $377.2mil

Distribution Rate: 7.10%

Total Leverage Ratio: 26.04%

52 Week Range: $22.85 - 30.33

Premium/Discount: -9.80%

Current Market Price: $23.71

NAV: $26.32

Expense Ratio: 1.45%

Here's why should consider buying JLS:

  • Strategic Market Opportunity - The current fund discount is -9.80%, which to some investors isn't that compelling, however, this is about 8% less than the 3 year average discount to net asset value and this discount level is the furthest from its net asset value since 2010, which means there is definitely something incorrectly priced about the way this closed end fund is trading. Not only is there a potential 8% upside in price appreciation, but during the upside rise in price, investors are paid a 7.10% distribution per year, accounting for a conservative 15% total return for JLS (assuming dividends are not reinvested).
  • CEF Diversification (mainly away from Equity heavy portfolios) - JLS invests in a couple of investment instruments consisting of mainly Non-Agency Residential MBS, Agency MBS CMOs, and Commercial MBS, Asset - Backed, and Covered Bond securities (which explain the moderate distribution rate).
  • Reasonable Expense Ratio - 1.45% is about the average across the high yielding closed end fund industry and it makes sense relative to the market capitalization of the fund. I will note that this may actually be too high for a fund that is leveraged over 20% and investing in asset backed securities, since the fund maintenance should be relatively low when pricing in the longevity of the investments.
  • Distribution Rate and Frequency - With a distribution rate of 7.10%, every investor's portfolio could find this fund useful from a monthly distribution perspective. When doing the math, and even leveraging JLS in a personal portfolio, that 7% distribution rate could turn into 9% (or more, depending on the amount of leverage taken) as your dividends reinvest in the fund to yield higher returns every month (note: only leverage your personal account if you understand the fees/costs associated with leveraging a closed end fund in your brokerage account).
  • Distribution Composition - JLS's dividend distributions are made up of fund income and long-term capital gains, which follow the objective the fund markets to investors. When it comes to distributions, the first thing an investor should always scrutinize is the composition of the dividends to determine how sustainable certain investments may or can be for a long-term income portfolio. For funds like JLS, any Return of Capital (ROC) would bucket JLS into the "do not invest" bucket, since funds like JLS are not supposed to be distributing the funds they are supposed to be using to grow and distribute income distributions with. There are some funds that are solely ROC funds, however, JLS and other funds with similar strategies are not to be mistaken for those types of funds (a good example of an ROC distributing fund is ETV, where the ROC distributions are explained. Read that article here).
  • Morningstar 4 Star Rating - The average Seeking Alpha investor generally does not assign Morningstar's rating system that much value when it comes to investment ratings, but when you do see a four or five star rated closed end fund and compare the funds you currently have in your portfolio (that may have lower or no ratings), wouldn't it be interesting to look into why that specific fund is rated four or five stars? I've always treated Morningstar ratings as additional information to give me perspective on what other investors, or rating agencies, think of that given closed end fund. I actually find the Morningstar rating system fairly credible and will definitely use it to influence my investment decisions.

Here are some investment detractive findings I found on JLS:

  • Negative UNII - Generally speaking, I tend to stay away from negative UNII closed end funds, but I see how JLS is making distribution payments using long-term capital gains to make up for the decrease in forecasted earnings, which for the experts in the MBS specialist teams is an expected strategy to make up for missing monthly investment earnings. I don't see this being a prolonged issue, but it is definitely an investment consideration.
  • Declining Payouts - Based on Morningstar's website, the fund use to payout $0.1725 (3/13/2013 payout) per month to investors as distributions, and the current distribution rate is $0.1405 (1/13/2014 payout). Overall, this fund looks like its management team has quite some work to do to guarantee consistent earning payments without the use of long-term capital gains to boost the attractiveness of the fund to speculative investors (this is a big consideration for long-term investors).
  • Will the Discount Gap Close? - This is the most important question every investor should consider since it would probably be the basis of the investment in the short-term (next 6 to 12 months). Based on statistical divergence and convergences of closed end funds, and their peer groups, the discount to net asset value divergence for specifically JLS is mathematically undeserved since the investment vehicles are relatively straight forward: Mortgage Backed Securities (which have monthly payouts at predetermined levels). From a statistical perspective, the price should theoretically converge to the 3 year average range, or closer to the net asset value, overtime as investors realize the market pricing inaccuracy.

Betalyst View: I use to find JLS unattractive for two reasons: 1) the yield was under 8% (automatically was factored out of my investment considerations) and 2) the investment strategy didn't exactly excite me (monthly distributing MBSs aren't really rocket science). To this day, the second point holds true, but the first point has changed course, presenting the fund at a more attractive yield and buying opportunity (with an 8% upside mentioned earlier). Overall, I'm proactively looking to take a position in JLS in the near future (next two months), and would consider allocating about 3% of my portfolio(s) to the fund to capture the opportunity. However, I will note that once the premium to net asset value climbs to 3 year average levels, this fund would lose its holding opportunity, in which case I would sell it for alternative opportunities. I will also note that the next few months of distributions would determine the fund management's ability to keep up with market expectations for MBS based closed end funds. Overall, keeping an eye on JLS, but not buying just yet.

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.