mREIT Preferred No Fluff Update - July 17, 2017

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Includes: ARI, NLY, PMT, RAS, TWO
by: Rubicon Associates

Summary

The universe yields just shy of 8% (7.95% - 2 bps lower than last week), and the optimal list yields 7.87% (also 2 bps lower than last week).

Investors pay approximately 290 bps for the preferred stability (-7 from last week) and receive over 563 bps above the risk-free rate (+5 bps from last week).

Preferreds underperformed equities with the rally in rates.

Welcome to another installment of the no fluff mREIT preferred update. All in all, mREIT preferreds performed okay last week - equities outperformed and preferreds didn't get much traction on the rates rally, but that isn't what we are really looking for in this class, is it? No, we give up yield versus the equities to reduce the volatility and just keep moving forward.

Before we jump in, a reader asked me why I don't give price targets for mortgage REITs. The answer becomes a question: what should the price targets be based off? Yield? I respond: yield relative to what - equities? Rates? Recent lows? It has been my experience (running institutional preferred stock portfolios) that price targets within the preferred market (especially the $25 par market) are difficult to arrive at and difficult to support (quantitatively or historically). If you are $0.10 away from a "buy", is the 1-2 bps worth it? How far apart are your "buy" and "sell" prices? Do you want to trade the preferreds, or are you looking to beat a yield bogey? If you are going to trade mortgage REITs, might I suggest the equities rather than the preferred stock? This way you will have vol to trade. A true dividend capture (buying just before it goes ex, and selling almost immediately after) doesn't really work, as that was a tax trade (QDI versus marginal tax rates) and most mREIT preferred dividends aren't QDI (for Annaly Series A, for example, $1.80 was taxed as ordinary income and $0.016 was QDI). To sum it up, if the yield is acceptable (the stripped and yield-to-call), trying to get positioned $0.01 cheaper might not be the best use of your time.

Okay, enough fluff, on with the stuff. The universe:

I have added Two Harbors (NYSE:TWO) preferred to the list as, frankly, I inadvertently left it off. This came to my attention when I wrote on the company's newest issue. PennyMac Mortgage Investment Trust (NYSE:PMT) is also included finally. Note that Apollo Commercial (NYSE:ARI) Series A is being called.

The "optimal" list - chosen based on price, stripped yield and yield-to-call:

The optimal list trails the universe by 8 bps, as higher yielding preferreds, such as those issued by RAIT Financial Trust (NYSE:RAS), only have one line item in the average.

Graphically, the stripped price is as shown below:

And the stripped yield:

As mREIT equities outperformed for the week, the cost of stability of the preferred market has decreased to 290 bps, 7 bps less than last week. Given the stability of the preferred market, I expect this gap to slowly increase.

This is graphically depicted as shown below:

As rates rallied last week and preferred stocks held in, the spread to risk-free has widened - this is the cost of investing in a more stable asset. The spread widened by 5 bps, which is both a positive and a negative (more of a positive, as it alludes to the stability of the preferred market).

This is graphically depicted as shown below:

Preferreds underperformed equities during the last week as equities rallied with rates:


Graphically, the distance of the current price from both the highs and the lows is as shown below:

The distance between the high and the low (an indicator of price volatility):

The table below presents an overview of the equities of the preferred issuers:

This is graphically depicted as shown below:

Book value change:

The "cushion" for the preferreds when viewed as the equity tranche of the capital structure compared to the preferred tranche and the amount of equity dividends that "cover" the preferred dividend, given the senior nature of the preferred dividend:

Finally, the swaps rates and mortgage rates. Swaps dipped, as did mortgage rates (a general rally in the rates complex):

Mortgages:

Bottom line

Performance was in line with expectations, or in other words, pretty stable. That is the attraction of the asset class and the reason why many invest in it. The carry versus rate alternatives continues to be attractive and is generally supportive of prices.

Errata: Annaly Capital Management (NYSE:NLY) did a secondary, putting more cushion below the preferreds. Good times for the preferred investor.

Disclosure: I am/we are long OAKS, MITT, NYMT, MTGE.

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.

Additional disclosure: I am long the common stock of LADR and MTGE and the preferred of OAK (Series A), MITT (Series B) and NYMT (NYMTO). I bailed out of NLY and CYS.

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