MFA Financial Needs To Take Additional Interest Rate Risk As Dividends Remain Sustainable

| About: MFA Financial, (MFA)


Rates will remain low for longer than expected by the market and company should not limit interest rate risk.

Company should take advantage of low yield environment.

Quarterly dividends are sustainable and current valuations are justified.

MFA Mortgage Investment Inc (NYSE:MFA) is an internally managed real estate investment trust (REIT) that invests in agency MBS, non-agency MBS and other related investments. The company finances its investments by borrowing short-term in the repo market. I continue to remain bullish on the company due to its well diversified portfolio and significant exposure on the credit side. I also believe that the company's attractive quarterly dividends are sustainable. However, MFA should take more interest rate risk, as rates will remain low longer than expected by the market.

Limiting Interest Rate Risk

The CEO of the company, Bill Gorin, said in the earnings call that the company would continue to position its portfolio to suit both expansionary and contractionary policies. "We remain positioned for a more flexible monetary policy by the Federal Reserve that will be driven by measures of labor market, inflation, and other economic data." The management has taken several initiatives to reduce interest rate risk for the company, as the net portfolio duration continues to remain low at 62bps in the third quarter. Firstly, the company is expanding its credit portfolio, and its agency RMBS portfolio is almost the same since the end of the first quarter. Secondly, within the agency portfolio, the company is heavily invested in hybrid and 15-year MBS.

However, I expect rates to remain low for longer than expected by the market. Although labor markets have shown significant improvements in the last six months, the slacks in the labor market continue to exist. In the last month, the labor force participation rate remained stagnant at 62.8%, just 10bps higher than the lowest rate since 1978. Similarly, average wage rate rose by $0.09, which translates into an increase of2.1% from a year ago. However, economists are expecting this number to be somewhere close to 3%. Moreover, rise in wages was also accompanied by an increase in average work week to 34.6 hours, which is the highest since May 2008.

Another important measure is inflation, and the Fed's preferred tool to measure inflation is consumption expenditure, which is well below the Fed's target of 2%, as shown in the figure below. Furthermore, in an updated forecast, the Fed lowered its forecast for inflation to 1%-1.6% in 2015. This means the Fed itself doesn't believe that inflation can reach 2%.

In the recent December meeting, the Fed made it clear that it will be "patient" when it came to raising interest rates, and the rise in interest rates will be driven by U.S. economic date. I believe the Fed will make sure that the impacts of the recession are completely eliminated from the economy before ending its expansionary monetary policy. Low inflation and the slacks in the labor market will continue to remain a concern for policymakers. So, what MFA needs to do is closely follow labor market and inflation trends, and adjust its portfolio accordingly.

Source: Market Watch

Strategic Initiatives

As mentioned earlier, MFA continues to increase its investments in credit-sensitive assets. The management has increased its investment in re-performing and non-performing loans (RPL/NPL), which has now reached $942 million in comparison to $493 million in the previous quarter. The RPL/NPL initiative is profitable for the company because it has a low duration and minimal interest rate risk. These loans are callable after 12 months and have a 300bps step up rate after 3 years, so the management expects them to be called before 3 years to avoid a rise in rates. Furthermore, the investment also has low credit risk, as it has credit enhancements of approximately 50%. Lastly, it also offers the better net interest spread than traditional agency RMBS, as shown in the figure below.

MFA also increased its allocation to high yielding residential whole loans by 89% to $113 million in the third quarter. This will help support the company's core EPS, as it offers the highest net interest spread in the portfolio. Another encouraging sign is that the company's credit profile continues to improve in the third quarter as well. In 3q'14, the management transferred $20.5 million from the credit reserve to accretable discount. This will eventually help increase the asset yield of non-agency MBS in the future and further improve the company's net interest spread.

Agency MBS

Non-agency MBS


Residential Whole Loan

Net Interest Spread





Source: Company's Earnings Report

Dividends and Valuation

In the third quarter, the company reported EPS and dividend of $0.20 per share. This translates into an attractive yield of 9.70%. I expect the EPS to improve in the fourth quarter because the company continues to divert its capital allocation to high yielding credit sensitive assets. Furthermore, CPR for the agency portfolio will remain low in the fourth quarter. This equals lower drag of premium amortization on EPS. In fact, the CPR for agency MBS in October fell to 12.7% in comparison to 18.3% in the third quarter. Lastly, the transfer of $20.2 million from the credit reserve will also improve the yield of the non-agency segment.

Currently, the company is trading at a P/BV of 0.99x ($8.21/$8.28). I believe the current valuations are justified, as it is not a pure play agency RMBS company and almost 50% of the assets are invested in the credit side.

Final Words

I believe rates will remain low for longer than expected by the market and the company should not limit interest rate risk, and should take advantage of the low yield environment. On the credit side, MFA has taken several initiatives, which would help boost the company's EPS. I also believe that quarterly dividends are sustainable and the current valuations are justified.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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