Subscribers had early access to this article, within about an hour of CMO's Q4 Release.
Capstead Mortgage Corporation (NYSE:CMO) delivered their earnings on 01/25/2017 and the interesting stories are already starting to pour in. My estimate for CMO's book value was $10.98; they came in at $10.85, short of my estimate by $.13. It looks like the largest factor was their earnings coming in weak again for the fourth quarter at $.14 compared to their quarterly dividend of $.23. However, earnings should be bouncing back in Q1 2017 absent another huge change in rates.
The Story For Q4 2016
Directly from the earnings release:
"Earnings for the fourth quarter were hampered by slower than anticipated declines in mortgage prepayment levels. As a result, portfolio yields did not improve as much as expected. While the 2016 refinancing wave peaked in September, declines in prepayment rates on ARM securities have lagged declines in prepayment rates on fixed-rate mortgage securities during the fourth quarter and in January 2017. However, with the sharp increase in interest rates post-election, opportunities for homeowners to refinance at lower rates have diminished considerably. This is expected to lead to lower mortgage prepayment levels in the coming months, benefiting portfolio yields and earnings."
The reason these prepayments are hitting in Q4 despite the rapid rise in rates is the drag time between the borrower agreeing to refinance the loan and the prepayments reaching the mortgage REIT. The prepayments coming in were all from loans scheduled prior to the election and the rapid rate increase that followed.
The CMO Strategy
Capstead Mortgage Corporation uses higher levels of leverage combined with a portfolio of agency ARMs (adjustable rate mortgages). Because the interest rate on the mortgages will reset, CMO benefits from the steeper yield curve without losing as much book value when rates increase dramatically. A book value decline of $.25, or 2.25%, should be one of the best values reported by any of the mREITs focused on agency RMBS. When management discusses the decline, they focus on the impact of a change in the value of assets and hedges, which drove a 1.4% reduction. The rest of the reduction was due to weak earnings relative to the dividend.
Here is management's commentary on the situation:
"This translated into a fourth quarter book value decline of only 1.4% due to changes in unrealized gains and losses on the portfolio and interest rate swaps held for hedging purposes. As a result, our fourth quarter economic return (change in book value plus dividends) is expected to significantly outpace the performance of our mortgage REIT peers holding longer duration portfolios that will be reporting in the coming weeks."
So Far in Q1 2017
I would expect CMO's portfolio value so far in 2017 to be roughly flat. It could be up or down by a few cents, but I don't see anything big impacting it. Their earnings for Q1 2017 should come in substantially higher than the performance for this quarter.
The other factor so far is peer comparisons.
The agency RMBS to LIBOR swap spread didn't look particularly appealing, but the yield curve was significantly steeper. For mortgage REITs focusing on fixed-rate RMBS in this environment, it would make sense to reduce hedge and take on duration risk to improve interest income. There are two major areas for an mREIT to try to earn their income. They can focus on the spread between RMBS and swap rates, or they can reduce hedging and focus on the spread between RMBS and short-term repurchase agreement rates. I expect most of them to choose the latter.
So far in the first quarter, we've seen rates move mildly higher, those fixed-rate portfolios should be suffering a little. Relatively, the strategy CMO is choosing should be winning. However, if rates gradually declined by 25 to 30 basis points across the yield curve, CMO wouldn't gain as much as their peers.
I like the way CMO's portfolio is structured for a period where I expect higher than normal volatility. I also believe CMO delivers on operational excellence by having a very low ratio of operating expenses to total equity. However, I also think the market has them at a near full valuation.
Instead, I suggest their preferred shares, which recently closed at $24.09. If interest rates do go lower (as most mortgage REITs are betting with their positive duration), those preferred shares could easily climb back to trade around $25. Meanwhile, the shareholder collects a 7.78% yield. Those shares trade under the ticker CMO-E, CMO/PRE, or CMO.PRE depending on your broker. I'm long CMO-E.
Whether CMO has to chop their dividend or not will depend on how much the prepayments decline as we progress into 2017. So far, it hasn't been covered, but the rising rates are very favorable for their strategy. As we get a couple of months further in, data on prepayments throughout the industry (though not specific to CMO) should start to flow in and make it easier to forecast their dividend sustainability.
I would be very bullish on CMO around $9.33. At their most recent price of $10.88, I don't see a great value play in the common stock. Knowing that they are very near book value, I would like to see them issuing new equity if they get the opportunity. With their internal management structure, the effective cost (relative to equity) would decline as they issued additional shares. That would mean better leverage on the fixed costs for the common shareholders. For the preferred shareholder, it would mean even better coverage.
Update: As of 2/14/2017, the latest price is $10.50. The rest of the analysis stands, but CMO is no longer close enough to BV to warrant issuing shares to drive leverage on fixed operating expenses.
If you want to learn more about investing in high yield instruments, specifically mortgage REITs and their preferred shares, check out the reviews from my subscribers. The Mortgage REIT Forum averages 3 articles per week. One provides updated book value estimates for several mortgage REITs and includes my ratings (adjusted each week). The second article rates the different preferred shares and shows investors which ones are offering the best bargains. The third is used to highlight individual stocks and market failures or to provide a sneak preview on the articles I'm planning to publish over the next couple weeks. If you're ready to take the plunge with a free trial, proceed straight to the Mortgage REIT Forum.
Disclosure: I am/we are long CMO-E.
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.
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