High Yields Shouldn't Be Picked By A Baby

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Includes: AGNC, AI, ARI, BXMT, CIM, EARN, GPMT, MFA, NYMT, PEI, PEI.PC, PEI.PD, TRTX
by: Colorado Wealth Management Fund
Summary

These high yields have soared - time to lock in some profits.

Investors need to be aware that mortgage REITs are not just a dividend yield. The fundamentals matter.

Confused about mREITs? Here are a few answers.

Preferred shares and baby bonds offer high yield alternatives for stable (less risky) income.

100% of our revenue from this article in the first month will be donated to a charity. In February, we will be supporting 2 Blondes All Breed Rescue.

We cover the mortgage REIT sector which may be confusing to some investors. If you're not focused on mortgage REITs, check out our latest guide on how to retire.

We're going to cover several mortgage REITs in this article. We provided a more extensive view of the sector and our top picks in a recent RapidFire update on mortgage REITs for subscribers.

Here are the securities we will cover in this article:

Source: This screenshot comes from our "Common Share Spreadsheet" tool which is available to all subscribers

Before we get started

Before getting into this article, we want to highlight a couple of terms. Specifically, you will see terms like "Widen" and "Tighten" used extensively. These terms refer to the difference between the expected yield on assets at recent prices and the cost to hedge those assets.

These metrics do not have to do with the shape of the yield curve. The shape of the yield curve can become "Flatter" or "Steeper", but it does not "Widen" or "Tighten". We will not be discussing the shape of the yield curve at any point in this piece as it has not changed substantially in the last couple of months.

Sector-wide factors

Book value per share should be up for almost every mortgage REIT relative to their fourth quarter ending values. Most of the damage to book value during the fourth quarter was a direct result of "spread widening". This is a phenomenon where the valuations on their assets (mortgage-backed securities) and the values on their hedges (LIBOR swaps and Treasury Futures) don't offset like normal.

We've seen those spreads coming back together so far in the first quarter (raising book value). The benefit to book value so far in the first quarter won't be near enough to offset the damage to book value in Q4, but it is setting mortgage REITs up for better 1st quarter results.

When these spreads "widen", it means a mortgage REIT can buy assets and hedge their duration risk while earning a larger "spread". That is positive for future dividend levels, so long as the mortgage REITs are actually using the opportunity to grow their assets.

In a nutshell, wider spreads enable stronger earnings for managers who lock in the wider spreads. However, in the short term, investors may focus only on the book value loss.

We handle these situations by modeling the book value loss but increasing our targets for price-to-book ratios.

Agency RMBS

Investors might reasonably wonder why we suggest mortgage REIT common shares are meant for trading when the return on each dollar of capital can be so high. That seems like a great point to address.

When a mortgage REIT buys Agency RMBS, they are buying a very high-quality asset. The buyer carries a guarantee of getting paid, so they don't have much credit risk. However, the owner of the Agency RMBS does face a significant challenge. While they know they will be paid, they don't know how quickly homeowners will "prepay" their mortgage. A "prepayment" is any time that the homeowner sends in capital to make an extra payment against the mortgage. Two common forms of prepayments are homeowners selling their house or homeowners refinancing their house. Either of those situations leads the owner of the Agency RMBS to receive their $100 of principal back. That can be unfortunate if the security was purchased for $102.

On the other hand, if mortgage rates increase significantly, then homeowners cut back on refinancing (in some cases they may even refuse to sell homes). In that scenario, the investor would like to be prepaid so they can eat the $2 loss and buy new securities at a higher rate. They could sell the security they own, but the price may have fallen from $102 to $98.

In finance, we say that the owner of the Agency RMBS is "short the call option". That means the homeowner has the right to prepay their debt. There are times when the investor might want the homeowner to prepay their debt, but that is precisely when prepayments are reduced.

Some investors are confused by the idea that a buyer at $98 would still be "short the call option" since the homeowner would need to pay $100 to settle the debt. Imagine purchasing a share of stock for $98 and selling a call option with a $100 strike for $1. If shares go over $100, you would expect the shares to be called away. Your upside would be limited because you were short the call option. The premise is similar for agency RMBS, except the process isn't nearly as efficient. Homeowners won't always refinance when it makes financial sense. They will also refinance sometimes when it doesn't make financial sense. However, on the whole, being short the call option is a negative aspect.

Agency CMBS

The Agency CMBS have substantial protection against prepayments. The mortgage REIT investing in these securities has more clarity in projecting how much cash they should get in each quarter. Because the buyer can be more certain about their future cash flows, they can hedge the securities more effectively. If you know that you'll need financing for an asset that pays 3.3% for 10 years with principal being repaid between 9.5 and 10 years from today, you could arrange a hedge to last 9.5 to 10 years.

Being able to hedge more effectively is appealing because it allows the REIT to run higher leverage for the same level of risk.

Alternative investment to mortgage REITs

Today, we are covering mortgage REITs without a buy rating on them. Since we believe they should primarily be used as trading securities, we will be suggesting investors look to mREIT preferred shares and baby bonds.

We suggest investors focus on preferred shares with lower risk ratings. We use risk ratings as a way to identify the amount of risk a company is taking on. Investors are used to the idea that high risk and high reward are linked. If higher risk always meant higher reward, it wouldn't actually be risk. This is one of the problems with investors thinking volatility and risk are precisely the same. It leads them to think anything volatile that plunges is preparing for an enormous boost higher to reward them for maintaining their position as the price crumbled.

After covering several mortgage REITs, we will cover one of the baby bonds which is similar to a preferred share.

If you want to know more about the difference between a preferred share and a baby bond, see 'A Guide To Investing In Preferred Shares'.

AGNC

When a mortgage REIT hedges out the duration exposure, they can run higher leverage and focus on the spread between assets and liabilities. If rates stay wide, net interest income looks great. If spreads tighten, book value rises. It is possible that spreads might widen further, but it seems unlikely without a major panic in the markets.

This concept of raising leverage when spreads widen is at the heart of how mortgage REITs should operate. You can see the increase in leverage for AGNC Investment Corp. (AGNC) below:

Source

AGNC decided to hedge their portfolio to the extent that their duration exposure was mostly gone:

Source: AGNC

For comparison, AGNC was carrying substantially more interest rate exposure 3 months earlier:

Source: AGNC

For a deeper look at which assets are most attractive currently, we should consider a slide from Ellington Residential Mortgage REIT (EARN):

Source

Considering those slides together, it makes sense for mortgage REITs to reduce their duration exposure and to look at Agency CMBS and AAA-rated CMBS as investment options.

We believe AGNC is one of the better mortgage REITs and has exceptional management. However, the price of the security is close to hitting our "overpriced" level. Shares are at a significant premium relative to our estimated book value.

MFA

MFA Financial (MFA) is modestly outside our target buy range. Most mortgage REITs to report so far have delivered disappointing commentary on book value. If that trend holds, it would be negative for MFA. Either way, we might see an offering soon which could give investors a chance to hop back in at a lower price point.

We covered MFA Financial in depth on The REIT Forum towards the end of 2018.

MFA Financial is one of the best mortgage REITs. They often trade at a price-to-book value ratio that is above average for their peer group. They have internal management and some unique aspects of their strategy. We waited a long time before purchasing shares of MFA Financial because we still require a material discount to book value before initiating positions.

We recently sold our position in MFA on 2/5/2019 for nearly a 10% gain (including dividends). We started a small position on 10/18/2018 for $6.99. We tripled our position in MFA on 11/1/2018 when the price was at $6.91.

MFA - why we took our profits

After trading significantly below book value, we were seeing several mortgage REITs move to trade near book value or slightly above book value. In these cases, we expect new shares to be offered. Since MFA Financial is internally managed, offering very close to book value would be accretive to earnings since it provides better scale on operating expenses. However, when a new offering is announced, it usually sends the share price lower.

Not only did shares rally significantly since our initial purchases of the stock, but MFA also significantly outperformed most other mortgage REIT stocks:

The chart above begins on November 1, 2018, and the prices are adjusted for dividends paid. During this time, MFA has been stellar and gives us a very healthy profit.

NYMT

New York Mortgage Trust (NYMT) carries the second highest ratio of price to tangible book value for the residential mortgage REITs. We estimate it to currently be around 1.12 (estimate from February 13, 2019). The only higher value belongs to Chimera (CIM). Our book value estimates rely on research from Scott Kennedy. Many mortgage REIT investors will know Scott Kennedy for his exceptionally accurate track record.

The preferred share market concurs with our assessment of risk as the preferred shares carry some of the highest coupon rates and yet, trade at significant discounts to face value. The combination gives the preferred a much higher stripped yield than most peer preferred shares. Therefore, our outlook on NYMT is bearish.

NYMT is internally managed which is normally a good thing for operating expenses. However, for NYMT, this is not the case. They have higher than average operating expenses.

Previously, most of the company's capital was in either residential or multifamily. Around 3% of the portfolio was allocated to "Goodwill" & "Intangibles".

Source

The latest presentation from the NYMT website is from March 2017.

The company allocated an even amount to both residential and multifamily. Within these subcategories, they can be broken down even more. The complexity of the portfolio doesn't make them better than other mortgage REITs, but the market has routinely given them a premium for it.

One of the problems for NYMT is the relatively high value of operating expenses compared to common equity. This ratio is important in evaluating how much a mortgage REIT can earn for their shareholders. Management's job is to invest the capital in bonds related to real estate. The characteristics of these securities can vary significantly, but the fundamental premise remains the same. They take the equity and invest it in some type of mortgage-backed security.

They leverage the initial position to enhance the total expected return. The net periodic income from that position is called the net interest margin.

The net interest margin is primarily used for 2 purposes. The first purpose is to pay management. Some investors might have thought it was to pay dividends.

Source

GPMT

Granite Point Mortgage Trust (GPMT) was a top performer lately. We sold our shares just before Christmas because we wanted to use the cash for PEI-D (PEI.PD). At the time, PEI-D was on an incredible sale. We closed the position on 1/16/2019 for a 19% gain.

The following chart from Schwab demonstrates:

  1. Where we had our large purchase on PREIT (PEI)

  2. Where we bought PEI-D

  3. Where we took gains on PEI-D

  4. Where we are swapping PEI for PEI-C (PEI.PC)

Source: Trade alert by The REIT Forum

When we closed our position in GPMT, it was not due to any significant decline in the fundamentals. We simply needed the capital available for the other investment.

We moved GPMT to a neutral rating on November 6, 2018, when shares hit $18.98:

Source

The Granite Point Mortgage Trust earnings call around that time was generally received well. It combined with their earnings release to drive GPMT higher on the day relative to their sector peers.

GPMT was the best performer by a significant margin, which led us to think that might be a reasonable place to reduce our rating. Sometimes these trends will continue, but it is more common to see them revert.

We would like to cover some of the technical aspects and a bit of the fundamental aspects when we changed our rating. The fundamentals were a critical part of the analysis, but the technicals helped us to pick the precise point. This is from our GPMT earnings update on November 6, 2018:

This chart shows where the ceiling appears to be forming for GPMT:

Source

When we look at a 3-month chart, we notice a similar trend:

Source: Schwab

It appears that is often a seller showing up each day willing to sell around $19.00, which makes it harder for further gains in share price to occur.

The final factor we're considering is that in previous cases where the market became more concerned about the segment or the economy, we've seen GPMT punished to an absurd degree:

Source: Schwab

Remember that these 4 REITs hold very similar assets. We've appreciated GPMT because they have traded at a lower price-to-book ratio and because their incentive fee kicked in at a higher level of 8% compared to the standard 7%.

Price-to-book for TPG RE Finance Trust (TRTX) and GPMT is now extremely similar. Apollo Commercial Real Estate Finance (ARI) and Blackstone Mortgage Trust (BXMT) still trade at substantial premiums, but we're no longer predicting a healthy premium to book as a likely scenario due to a slight weakening in fundamentals for future results.

Because of BXMT's exceptional track record, investors are probably going to require a higher dividend yield from GPMT.

AI

Arlington Asset Investment Corporation (AI) is around the middle of the neutral range. It's no longer a great bargain but not overvalued either.

We've highlighted the corporation, which functions much like a mortgage REIT, on several occasions. Usually, it was highlighted for negative factors such as "garbage" Core EPS and expected dividend cuts. The dividend fell from $.625 to $.375 per quarter, so those criticisms were accurate.

Source: Seeking Alpha

Things started to get interesting when shares traded at an enormous discount to estimated current book value in the final months of 2018.

Source: Seeking Alpha

We were bullish in late 2018 on AI because we saw a significant discount to our estimate of current book value. We also saw nothing to suggest another dividend cut was in the immediate future (substantial risk medium and long term). However, there is very little professional research on AI and many investors have no idea how to value the company. Consequently, the price can be exceptionally inefficient.

We've hammered repeatedly on the point that Core EPS for AI does not matter. It doesn't matter because AI includes low-quality adjustments and deliberately designs hedging expenses to flow outside Core EPS.

Given the rally this year on AI, we are neutral on the company.

AI baby bond

AI has a preferred share and 2 baby bonds:

Source: The REIT Forum

AIC is $0.17 under our buy range right now. AIC is one of the two baby bonds and carries less risk than the preferred shares. The reason it carries less risk is that in the event of a liquidation, baby bond shareholders come before the preferred shareholders.

AIC remains a top choice here but beware of the liquidity. The liquidity is dreadful here. Traders who have free trades credited to their accounts can still trade here with low limit-buy orders and high limit-sell orders. Without free trades, getting executed for 1 to 5 shares is very annoying. The risk rating of 3 is a bit high for the buy-and-hold investor, but the maturity on these baby bonds (3/15/2025) ramps up the total return. Investors are expecting to get about $1.81 in capital gains by simply holding to maturity, though AI does take more risk than other mortgage REITs.

Final thoughts

The mortgage REIT sector has bounced back dramatically since late December when almost everything was on sale. Given the solid bounce, we've sold a few investments since then for healthy profits.

Several mortgage REITs have entered the "overpriced" category. Therefore, we recommend investors be very cautious when deploying capital. Overall, the sector appears almost fully valued.

In this article, we have primarily covered mortgage REITs that are trading in the neutral range. However, there are several other mortgage REITs and quite a few are within the overpriced range.

Diversification

While most of our coverage is on REITs with far less than average risk, The REIT Forum still recommends diversifying. We invest the substantial majority of our portfolio in REITs and preferred shares. We suggest that investors choose a maximum allocation using our risk ratings combined with their risk tolerance. Each of our risk ratings connects with a suggested maximum allocation. The maximum allocations generally range from 1% for higher risk options to 6% for our lowest risk choices. By diversifying among our choices investors can build a portfolio with a less volatile value and more consistent dividend growth. We do not believe mortgage REITs are a good fit for buy-and-hold investors. We consider mortgage REITs to have a substantial amount of risk. However, several of their preferred shares have dramatically less risk on the fundamentals and lower volatility. Within the preferred shares, there are several great opportunities for buy-and-hold investors.

Ratings

Bearish ratings: NYMT

Neutral ratings: AGNC, MFA, GPMT

Buy ratings: AIC

Update: This article was submitted 2/18/2019. At the time, the latest share price for AI was $8.84 as shown in our charts. At $8.84, we were very content to end our bullish rating and switch to a neutral rating.

The article came out on the morning of 2/20/2019. This is a very reasonable delay between submission and publication for public articles. Between those two dates, AI released their fourth-quarter earnings and announced a share offering. The price tanked from $8.84 at submission to $8.10 by the end of 2/20/2019.

At $8.10, shares are not quite cheap enough to issue a fresh buy alert, but they aren't expensive enough to issue our downgrade to a neutral rating either. Consequently, we are not posting either a "buy" or "neutral" rating for AI.

Disclosure: I am/we are long AGNCB, AIC, MFA-B, NYMTN. 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.