MORL: Dividend Yield Of 27.4% Makes It Still Compelling

| About: UBS ETRACS (MORL)
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Summary

My projection for the April 2016 monthly MORL dividend is $0.6918.

I remain bullish on MORL despite, and in some respects because, of the recent collapse in mREIT prices.

The new normal will be lower interest rates for much longer. Negative interest rates around the world support this.

The Federal Reserve is not keeping interest rates abnormally low, other factors are in play.

I remain bullish on the UBS ETRACS Monthly Pay 2X Leveraged Mortgage REIT ETN (NYSEARCA:MORL) despite, and in some respects because, of the recent collapse in mREIT prices. My view is based primarily on my outlook for interest rates and MORL's enormous yield. The mREITs that comprise MORL's portfolio have been under selling pressure since the 2013 "taper tantrum." The bearish argument against the mREITs was then and is now that higher interest rates are imminent. I disagree and think that interest rates will remain relatively low for longer than many market participants believe.

My projection for the April 2016 dividend for MORL and its' new, effectively identical, sister the UBS ETRACS Monthly Pay 2X Leveraged Mortgage REIT ETN Series B (NYSEARCA:MRRL) is $0.6918. Most of the MORL components pay dividends quarterly. Only two of the 25 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 the components that have ex-dates in March 2016 will contribute to the April 2016 dividend. The table below shows the weight of each of the mREITs that now comprise the index upon which MORL and MRRL are based. For the components that will contribute to the April 2016 dividend, the price, ex-date, dividend and the contribution to the dividend are shown. The projection for the $0.6918 April 2016 dividend is calculated using the contribution by component method. The Market Vectors Mortgage REIT Income ETF (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.

Chimera Investment Corp (NYSE:CIM) paid a special $0.50 dividend with an ex-date in March 2016, which adds to the April 2016 dividend. Two Harbors Investment Corp (NYSE:TWO) reduced its' quarterly dividend to $0.23 from the previous $0.26. Pennymac Mortgage Investment (NYSE:PMT) did not declare a quarterly dividend with an ex-dates in March 2016 as of this writing so it did not contribute to the April 2016 dividend. Istar Inc (NYSE:STAR) has not paid any dividends since 2008.

There was also an increase in the net asset or indicative value of MORL from $11.63 at the end of February 2016 to $12.51 on March 24, 2016. As the value of the closed-end funds in the portfolio increase, portfolio assets must be increased to maintain the leverage level. This increases the dividend, separate from any changes in the dividends paid by the mREITs in the portfolio. The relationship between the net asset value of a 2X leveraged ETN and the dividend is explained more fully in "MORL's Net Asset Value Rises - Implications For The Dividends."

The belief that interest rates will rise significantly is held by many market participants who think that the Federal Reserve is artificially depressing rates below what would be a "normal" level. I disagree. As I indicated in "The Federal Reserve is actually propping up Interest Rates and what that means for Mortgage REITS," one benchmark rate that he Federal Reserve has absolute control of is the rate paid on reserves deposited at the FED. That rate is now 50 basis points, and was 25 basis points in until December 2015 after being zero since the inception of the FED in 1913 and almost a hundred years after that.

At the biannual monetary policy hearings, required by law, congressmen were becoming upset about the billions of dollars that were being directly transferred to the banks from the American taxpayers as a result of paying banks interest on reserves. From the inception of the Federal Reserve in 1913 until a few years ago banks never were paid on reserves deposited at the Federal Reserve. This was true even when the prime rate reached 21% in 1981. Janet Yellen, Federal Reserve Chair, explained that Federal Reserve was paying banks on reserves because that was the only way to get market interest rates up. She asserted that the traditional Federal Reserve tools of raising the target rate on Federal Funds or raising the discount rate would not be effective in forcing banks to increase the interest rates they charged borrowers on loans or paid depositors. Congressmen from both parties were no completely satisfied by Yellen's explanation.

I regard Yellen's explanation as supportive of my assertion in the above mentioned article that absent the policy of paying banks on reserves, the rate on US treasury bills would be actually negative. Throughout the industrial world, in many countries their equivalent of treasury bills are actually negative. Among major developed countries only in the USA are the monetary authorities trying to increase interest rates. In Europe and Japan many central banks have allowed short-term rate to fall into negative territory. German 10-year bonds are now only 0.15%. Japanese 10-year bonds now have negative interest rates.

More important than the issue of whether interest rates would be negative absent Federal Reserve policy, is the question of why interest rates have been so low for so long. The world is clearly not in the grip of 1930's style unemployment or deflation. My view is that interest rates are low because of the tremendous imbalance between the amount that savers have to lend and invest as compared with opportunities such capital to be deployed.

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. The wealthy clearly have lower marginal propensities to consume. As I explained in "A Depression with Benefits: The Macro Case for mREITS":

..In free-market capitalism, capital generates income for the owners of the capital which in turn is used to create additional capital. This is very good. Sometimes, it can be actually too good. As capital continues to accumulate, its owners find it more and more difficult to deploy it efficiently. The business sector generally must interact with the household sector by selling goods and services or lending to them. When capital accumulates too rapidly, the productive capacity of the business sector can outpace the ability of the household sector to absorb the increasing production.
The capitalists, or if you prefer, job creators use their increasing wealth and income to reinvest, thus increasing the productive capacity of the business they own. They also lend their accumulated wealth to other businesses as well as other entities after they have exhausted opportunities within the business they own. As they seek to deploy ever more capital, excess factories, housing and shopping centers are built and more and more dubious loans are made. This is overinvestment. As one banker described the events leading up to 2008 - First the banks lent all they could to those who could pay them back and then they started to lend to those could not pay them back. As cash poured into banks in ever increasing amounts, caution was thrown to the wind. For a while consumers can use credit to buy more goods and services than their incomes can sustain. Ultimately, the overinvestment results in a financial crisis that causes unemployment, reductions in factory utilization and bankruptcies all of which reduce the value of investments.
If the economy was suffering from accumulated chronic underinvestment, shifting income from the non-rich to the rich would make sense. Underinvestment would mean there was a shortage of shopping centers, hotels, housing and factories were operating at 100% of capacity but still not able to produce as many cars and other goods as people needed. It might not seem fair, but the quickest way to build up capital is to take income away from the middle class who have a high propensity to consume and give to the rich who have a propensity to save (and invest). Except for periods in the 1950s and 1960s and possibly the 1990s when tax rates on the rich just happened to be high enough to prevent over-investment, the economy has generally suffered from periodic over-investment cycles.

World-wide, the shift in income to the rich and away from the middle class has been mainly accomplished by having the tax rate on the types of incomes that the wealthy receive such as dividends, capital gains and corporate profits much less than the tax rates on wages. Warren Buffett the CEO of Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) said "Through the tax code, there has been class warfare waged, and my class has won," Buffett told Business Wire CEO Cathy Baron Tamraz at a luncheon in honor of the company's 50th anniversary. "It's been a rout." Shifting income to the rich by taxing dividends, capital gains and corporate profits much less than the tax rates on wages also tends to make even more funds available for investment since when investment is taxed relatively less more funds are made available for investment.

Professor of Economics Emeritus at the University of Massachusetts and Producer of the Economic Update podcast, Richard D Wolff. puts it even more harshly and says "America is now a place where, to be a credible political candidate, you have to satisfy 500 people who sit at the top of the economic ladder of this society. And if you manage to displease any significant portion of them, your political career is either over or capped at a point of incapacity to do anything, no matter what the mass of opinion is in the country."

Buffet and Wolf are correct in terms of tax policy but not so much as to government spending. Across the political spectrum in the USA and to a greater or lesser extent the rest of in developed world there is a rough consensus on the magnitude of government spending should be. The Republicans want somewhat more defense spending and the Democrats want somewhat more nondefense spending, but both seem to agree on about how much total government spending should be relative to the size of the economy. Thus, there is very little effort to restrain government spending.

The laws of supply and demand apply differently to the market for loanable funds as compared to commodities. With commodities, equilibrium reached when the quantity supplied is equal to the quantity demanded. The debt or loanable funds market is more complex. A simple example illustrates this. An increase in government deficits accompanied by a commensurate increase in the issuance of government debt would normally be thought of as causing an increase in interest rates. However, the cause and/or purpose of the government deficits have a tremendous impact in terms of how interest rates are affected.

A government deficit for the purpose of funding a tax cut for those with high propensity to save has a much different impact on interest rates than the a deficit of similar magnitude who purpose is to fund an increase in social or defense spending. When the Federal government sells bonds and uses the proceeds to cut taxes on the wealthy, who in turn now have more money to lend, the net effect is to push down interest rates. This is especially true when the central banks are the buyers of much of the government debt.

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, will only result in weaker economic activity. Lower rates are by far the best environment for leveraged ETNs such as the UBS ETRACS Monthly Pay 2xLeveraged CEF (NYSEARCA:CEFL).

In an interview about the proposed "Buffett Rule," T.J. Rogers the CEO of Cypress Semiconductor Corporation (NASDAQ:CY) inadvertently illustrated the potential perils of over-investment for an economy. Warren Buffett had proposed the "Buffett Rule" which would impose a minimum tax of 30% on incomes above one million dollars. Rogers explained to Larry Kudlow on CNBC's Kudlow Report on May 16, 2012, why he opposed the Buffett Rule. Rogers said that he spends less than 1% of his income on his living expenses and invests the other 99% in creating new businesses and increasing the productive capacity of the businesses he already owns. If he had to pay taxes pursuant to the Buffett Rule he would not be able to invest as much. Clearly, someone who invests 99% of their income will see his wealth grow exponentially as long as his investments are at all productive. It would not take too many members of the top 1% investing 99% of their income before they would be unable to deploy their capital productively. This would be a classic example of capital accumulating faster than consumers' incomes. Consumers would not be able to buy all the goods and services produced by the over investment.

My view is that unless capital stops accumulating at much faster rates than opportunities to deploy the capital, interest rates will remain low. Only a massive return to tax policies that existed before, as Buffet put it, his class won, could cause interest rates to get back to what was normal in the past.

This interest rate environment should be very good for mREITs and MORL in particular. One could argue that my view on interest rates has prevailed for the last three years and mREITs have declined in price over 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 very 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.

The dramatic decline in all of the UBS (NYSE:UBS) 2X leveraged ETNs has prompted some fears that UBS might redeem them at net asset value if prices fall to $5. If the market collapses to that extent, the fact that the UBS 2X leveraged ETNs are callable then is probably the least of your problems. In any case, a holder of MORL or MRRL who wished to stay invested after such a call, could buy MORT with the proceeds from the redemption. They would have to arrange their own leverage if they still wanted to be 2X leveraged at that time.

The most bullish environment for the mREITs and thus MORL, MRRL and MORT is when the Federal Reserve reduces interest rates or is expected to do so. Now, there can be some hope, however slight, that the Federal Reserve actually reduces interest rates from current levels. There is one thing about the recent Federal Reserve decision to increase rates that can absolutely be construed as positive for those still constructive about the mREITs. Now, in contrast to before December 15, 2015, there is some possibility that the Federal Reserve will cut interest rates. Obviously, a zero interest rate policy meant no further rate cuts were possible, or at least that was thought to be the case before the European monetary authorities cut their deposit rate below zero. The dream by mREIT investors of a 2016 rate cut may not be as far-fetched as it seems. Since the 2008 financial crisis every central bank in a developed country that has tightened monetary policy had to reverse course and lower rates in response to weakening economic conditions.

In theory it is illogical for an mREIT to trade at a large discount to net asset value. If you or an institution held a portfolio of mortgage-backed securities that was financed using short-term borrowing, you would not value it at anything other than net asset value, based on the belief that interest rates were going up in the future. There is some argument to be made that mREITs and closed-end funds trade at discounts due to the fees that they charge.

Discounts to net asset value can be reduced when an mREIT buys back its shares at a discount to net asset value. This also has the beneficial effect of automatically increasing the book or net asset value. Many mREITs have outside managers and are thus reluctant to buys back shares since it reduces the management fee. Some mREITs have bought the shares of other mREITs at large discounts to net asset value. This has the effect of possibly increasing value without lowing the management fees, but does not automatically increase book or net asset value the way that buying back the mREITs own shares does.

The possibility of an activist to take control of an mREIT or force share buybacks by threatening to take over the mREIT via a tender offer or proxy fight is always on the minds of mREIT managers. This could be both a cause of and caused by the large discounts to net asset value that many mREITs are trading at. One defense mREIT managers have against takeovers is complexity. Agency Mortgages are fairly easy to value and/or liquidate. However, the various complex swaps and swaptions that mREITs use to hedge interest rate risk are another story. These complex derivatives could be difficult for a potential takeover activist to value and/or liquidate. Thus, complexity may dissuade potential takeover activists and could also be contributing to the large discounts

For the three months ending April 2016, the total projected dividends are $0.7671. The annualized dividends would be $3.0683. This is a 24.4% simple annualized yield with MORL priced at $12.56 On a monthly compounded basis, the effective annualized yield is 27.4%.

Aside from the fact that with a yield around 25%, even without reinvesting or compounding you almost get back your initial investment in only 4 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 27.4% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $335,080 in five years. More interestingly, for those investing for future income, the income from the initial $100,000 would increase from the $27,400 initial annual rate to $91,675 annually.

Holdings of MORL, MRRL and MORT as of March 24, 2016, weights at month end February 2016

Name

Ticker

Weight

Price

ex-div

dividend

frequency

contribution

Annaly Capital Management Inc

NLY

15.48

10.44

3/29/2016

0.3

q

0.1113

American Capital Agency Corp

AGNC

10.1

18.43

3/29/2016

0.2

m

0.0274

Starwood Property Trust Inc

STWD

6.1

18.89

3/29/2016

0.48

q

0.0388

Chimera Investment Corp

CIM

5.09

13.78

3/29/2016

0.98

q

0.0906

Two Harbors Investment Corp

TWO

4.9

7.92

3/29/2016

0.23

q

0.0356

New Residential Investment Corp

NRZ

4.86

11.51

3/22/2016

0.46

q

0.0486

Blackstone Mortgage Trust Inc

BXMT

4.74

26.45

3/29/2016

0.62

q

0.0278

MFA Financial Inc

MFA

4.63

6.65

3/23/2016

0.2

q

0.0348

Hatteras Financial Corp

HTS

4.58

14.4

3/30/2016

0.45

q

0.0358

CYS Investments Inc

CYS

4.5

7.94

3/8/2016

0.26

q

0.0369

Invesco Mortgage Capital Inc

IVR

4.29

11.85

3/23/2016

0.4

q

0.0362

Colony Financial Inc

CLNY

3.85

16.43

3/29/2016

0.4

q

0.0235

Pennymac Mortgage Investment

PMT

3.46

13.37

12/23/2015

0.47

q

 

Capstead Mortgage Corp

CMO

3.28

9.88

3/29/2016

0.26

q

0.0216

Apollo Commercial Real Estat

ARI

3.18

16.45

3/29/2016

0.46

q

0.0222

ARMOUR Residential REIT Inc

ARR

2.9

21.1

3/11/2016

0.33

m

0.0113

Hannon Armstrong Sustainable Infrastructure Capital Inc

HASI

2.59

18.66

3/28/2016

0.3

q

0.0104

Redwood Trust Inc

RWT

2.46

12.31

3/14/2016

0.28

q

0.0140

American Capital Mortgage Investment Corp

MTGE

2.35

14.58

3/29/2016

0.4

q

0.0161

Istar Inc

STAR

1.99

9.16

       

New York Mortgage Trust Inc

NYMT

1.87

4.5

3/23/2016

0.24

q

0.0250

Anworth Mortgage Asset Corp

ANH

1.6

4.77

3/29/2016

0.15

q

0.0126

Resource Capital Corp

RSO

1.22

11.42

3/29/2016

0.42

q

0.0112

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.