Seeking Alpha

mREIT-Based ETNs Now Have A Larger Role In The 15%+ Current Yield Constrained Portfolio

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Includes: AGNC, BDCL, CEFL, MORL, MORT, MRRL, REML, SMHD
by: Lance Brofman
Summary

Junk bonds and 2X-Leverage ETNs are almost the only securities with current yields exceeding 15%.

The increased risk of bad-faith bankruptcies suggests that 2X-leveraged ETNs should now play a larger role in 15%+ current yield portfolios.

The cessation of the Federal Reserve tightening program suggests that mREIT-based 2X-leveraged ETNs, MORL, MRRL and REML should play an increased role in such portfolios.

There are numerous diversification, arbitrage and hedging opportunities in the 2X-leveraged ETN sector.

Status of the 15%+ Current Yield Constrained Portfolio

I maintain a portfolio constrained to only contain securities with current yields in excess of 15% at the time of purchase. Other constraints include the typical IRA and other retirement account restrictions that preclude borrowing on margin and the use of futures contracts. I suspect that there are many individuals, particularly those either partially or totally retired, who either have somewhat similar constraints or could possibly benefit from adopting them.

Given those constraints, the universe of possible investments is very limited. Other than junk bonds and other securities issued by individual distressed entities, in order to meet the 15%+ constraint, my primary investment focus in the quest for 15%+ current yield has been and is, on 2x Leveraged High-Yield ETNs. Junk bonds with current yields above 15% have always been risky. They have become even more riskier recently. There has always been bankruptcy risk associated with very high yield bonds. Of course, in many cases bankruptcy is unavoidable. However, in some cases corporate management seeks bankruptcy because that is what is best for them personally. In some industries managements have been more inclined to seek bankruptcy than others. Some managements of airlines and steel companies treat chapter 11 as a “spa” where they can rid themselves of pesky union contracts, common shareholders, creditors and leases while senior management basks in retention bonuses while plotting to maximize their take in new stock when the company emerges from chapter 11 or their personal rewards when the bankrupt company sells assets to vulture investors at unfair prices. (See Polaroid and Bethlehem Steel for egregious examples.) In some companies in some industries, bankruptcy could be considered as part of their business plan.

I am not trying to pile-on Donald Trump. However, he can be partially blamed the recent spate of bad faith corporate bankruptcies, and it has nothing to do with any of his economic policies. Not only did everyone who ever bought any stock in any public Trump entity end up with nothing. But most unusually, all of the public buyers of mortgage bonds on any of the Trump casinos also eventually ended up with zero recovery. That is almost unheard-of. In almost all other casino bankruptcies, publicly held mortgage bondholders had significant recoveries. The general public did not pay much attention when then candidate Trump bragged about how much he personally made from the casino bankruptcies (well after the statute of limitations for bankruptcy fraud had expired). However, you can be sure that managements of every distressed public company paid rapt attention. A flood of bad faith bankruptcy filings has ensued.

From some management’s perspective, a bad-faith bankruptcy that wipes out the common shareholders and leaves management with a bigger percentage stake than they held before the filing, in an entity with much less debt, is the preferred solution. That is unfortunately, sometimes the case, even if there are many ways to avoid bankruptcy in that distressed corporation's situation. After Trump’s bragging about how much he took out of his bankruptcies, bankruptcy appears to be now more of the first resort than the last resort for some distressed companies.

This tendency to seek bankruptcy and particular bad-faith bankruptcies has led me to reduce the emphasis on junk bonds in the 15%+ Current Yield Constrained Portfolio. It has also led me to give more credence to the "bet on the jockeys, not the horses" investment philosophy. This school of thought emphasizes the quality of management, more than a corporation's assets and operations. In the case of junk bonds, it is not the skill or abilities of management that I am interested in. Rather, I look for a management where especially the chief executive officer seems fanatically determined to avoid bankruptcy.

One such chief executive officer I remember fondly, is Lourenco Goncalves chairman, president and chief executive officer of Cleveland-Cliffs, Inc. (CLF). At the end of 2015 and beginning 2016, I listened to some conference calls where Goncalves was ranting against those who had shorted CLF stock and who were predicting bankruptcy for the company. When I heard his almost deranged-sounding vows that the shorts would never win, my thought was, that there is a company whose bonds I want to own. I bought some CLF bonds at prices in the low teens. Most of the bonds have since been called at par or a premium. The only one I still own is the 6.25% 10/01/2040 that I bought on January 22, 2016 at $11.50. The last trade for that bond on April 22, 2019 was $86.86. Unfortunately, there are many managements of distressed companies that assert either explicitly or implicitly on conference calls that they will be easily able to avoid bankruptcy and then quickly do file chapter 11.

The net takeaway from the sad experience in the high-yield debt market, has led me to focus more on instruments that generate 15%+ without taking much credit risk. That leaves mainly 2X-leveraged mREIT ETNs. Many of the mREITs in the indexes that the 2X-leveraged mREIT ETNs are based, on have significant amounts of agency mortgage-backed securities in their portfolios. Agency mortgage-backed securities do have significant interest rate risk, but very little credit risk.

Prospects for the 2X-leveraged mREIT ETNs

As described in my July 11, 2013 Seeking Alpha article, "A Depression With Benefits: The Macro Case For mREITs," my macroeconomic rationale for investing in UBS ETRACS Monthly Pay 2X Leveraged Mortgage REIT ETN (MORL) - the only 2X-leveraged mREIT ETN in existence at that time - was based on the premise that government policies shifting the tax burden from the rich and onto the middle class results in much more funds being available for investment relative to productive uses for those investable funds. That tends to put downward pressure on interest rates.

From July 11, 2013 to April 22, 2019, the total return on MORL assuming reinvestment of dividends, was 147.66%. For that 5.78-year period the average annual return was 16.98%. That does not include my projected May 2019 monthly dividend of $0.1339 for MORL and its' essentially identical in all economic respects, twin, UBS ETRACS Monthly Pay 2X Leveraged Mortgage REIT ETN Series B (MRRL).

MORL and later MRRL and the Credit Suisse X-Links Monthly Pay 2x Leveraged Mortgage REIT ETN (NYSEARCA: REML) have been the primary instruments by which I have attempted to utilize my longer-term macroeconomic interest rate outlook to manage the 15%+ current portfolio. My interest rate outlook was additionally, and still is, based on the premise that contrary to the opinion of most financial market participants, the Federal Reserve has been and still is keeping interest rates higher than what a free-market outcome would indicate. This was explained in my 2013 article Federal Reserve Actually Propping Up Interest Rates: What This Means For mREITS. There has been a very large degree of uncertainty regarding the possible events and factors that could influence the outlook for mREITs and the 2x Leveraged High-Yield mREIT ETNs. Some potential risks appear to have diminished while some have intensified. While my view regarding the Federal Reserve propping up interest rates has not been universally adopted, the Federal Reserve has stated that they do not plan on increasing rates in the near-term and some observers are predicting that the next move by the Federal Reserve will be to lower rates.

The greatest risk associated with the 2X-leveraged mREIT-based ETNs is interest rate risk. Higher interest rates lower the value of the mortgage-backed securities held by the mREITs that comprise the indices upon which 2X-leveraged mREIT-based ETNs are based. The mREITs themselves borrow money to finance their holdings of mortgage-backed securities. Higher interest rates reduce the ability of the mREITs to pay dividends since higher rates increase their interest expense. Additionally, 2X-leveraged mREIT-based ETNs implicitly borrow at some LIBOR-based rate which provides the 2X leverage, and thus higher interest rates reduce the dividends that 2X-leveraged mREIT-based ETNs pay. While typically called dividends, the monthly payments from the 2X-leveraged mREIT-based ETNs are technically distributions of interest payments on the ETN notes based on the dividends paid by the underlying mREITs that comprise the index, pursuant to the terms of the indenture.

The relationship between interest rates and the Federal budget deficit has been a matter of concern for many decades. Clearly, borrowing by the US Treasury to finance the deficit tends to put upward pressure on interest rates. A related classic risk is that which occurs when the Federal Reserve acts to punish what it perceives as bad government policy, by raising rates. From the late 1970s until, arguably 2007, the Federal Reserve at times, used monetary policy to dissuade politicians from what the Federal Reserve considers profligate fiscal policy. The term "bond market vigilantes" referred to financial market participants who voted with their money against the inflationary impacts of government deficits by selling treasury securities. However, it was the Federal Reserve that took on the major role of punishing politicians when it considered fiscal policy too inflationary.

There are a number of risks to the financial markets that were not much on anyone's radar a few years ago. These include protectionism. All trade restrictions result in "dead-weight loss," which occurs when the benefits to the favored entities are always less than the costs to the many losers who pay higher prices. On balance, this makes the entire population poorer. Protectionism would result in higher input costs and shift the aggregate supply curve to the left. The resulting higher inflation would inevitably increase interest rates and depress economic activity. See Trump's Trade Policies: America's Brexit?, for a discussion of the risks of protectionism

A new set of risks that I had not previously considered particularly relevant has arisen since the 2018 election. There are some newly elected Democrats and others that appear to be favoring far left policies that have previously been tried and subsequently been rejected and reversed to a major extent, in countries such as France, Sweden and the Netherlands. It is unlikely that these could ever be enacted in the United States. However, many things have taken place in the last few years that may have previously been considered unlikely. Those far left policies such as increasing the minimum wage to a level where a large portion of the workforce is covered by it, as is the case in France, are distinct from adopting modern social welfare policies that are in place in every developed country except for America, such as controlling health care prices. See Single Payer, Medicare-For-All And The Investment Implications.

Addressing the acceleration in inequality caused by the tax code is not just a concern of those on the left. There is a growing view that the 2017 tax bill went too far in what Warren Buffett, CEO of Berkshire Hathaway (BRK.A) (BRK.B), was describing when he said that "through the tax code, there has been class warfare waged, and my class has won. It's been a rout." Whatever one thinks of the advisability of enacting legislation that reverses the massive shift in the tax burden onto the middle class and away from the rich, it could have negative implications for the financial markets. Since shifting the tax burden from the rich and onto the middle class results in there being more funds being available for investment, reversing that results in less funds being available for investment.

The probability of the 2020 election resulting in a change in the tax code that significantly reverses the massive shift in the in the tax burden away from the rich and onto the middle class is still very probably low as long as the Democrats continue to combine such tax proposals with plans to spend the proceeds on various social programs like free college tuition. However, a plan to raise taxes on those with assets above $50 million and/or incomes above $10 million and use all of the proceeds to reduce the taxes on everyone else might have a much higher probability of being enacted.

It is hard to envision the Democrats being politically savvy or ideologically flexible enough to embrace a policy of directly shifting the tax burden away from the middle class and onto the rich. The Democrats have generally been deluded in their belief that the current level of taxes on the middle class is politically sustainable. In Hilary Clinton's speech announcing her candidacy, she said that the middle class pays too much taxes. She never mentioned a middle class tax cut again. Presumably due to pressure from Sanders, who pushed her to the left, which severely hurt her chances in the general election. Most Democrat politicians are not aware that by far the best thing government could do for most middle-class households would be to lower their taxes. Thus, in many cases, middle-class voters have been willing to grasp at any chance they think could lower their tax burden, and thus support candidates who promise them a tax cut, no matter how odious the candidates might be otherwise.

As was discussed in: Bank Issues Could Impact 20% Yielding ETNs, recently, a French court ordered Switzerland’s largest bank to pay 4.5 billion euros ($5.1 billion) in fines and damages for helping wealthy French clients evade tax authorities. It is not inconceivable that zealous government authorities could impose such draconian fines and penalties, so as to cause the demise of one or more major financial institutions. That could impact the world economy in a way similar to the collapse of Lehman in 2008. Also relevant, is that UBS is the sole source of the interest and principal payments made by the ETNs it sponsors. The ETNs are notes, and thus obligations of UBS.

A financial crisis of the magnitude of that which ensued after the collapse of Lehman in 2008 would bring drastically lower interest rates, especially short-term interest rates on instruments deemed to be essentially risk free. That would be very good for agency mortgage-backed securities and mREITs that hold them. The 2X Leveraged Mortgage REIT ETNs would additionally benefit as long a LIBOR moved in conjunction with other short-term interest rates on instruments deemed to be essentially risk free, such as treasury bills. MORL, MRRL, and REML effectively borrow at a rate determined by LIBOR. A financial crisis might cause the spread between LIBOR and treasury bills to widen, that might adversely impact the implicit interest expenses that MORL, MRRL, and REML incur due to their leverage.

Diversification, Hedging and Arbitrage in the 2x Leveraged High-Yield ETN Sector

I have utilized UBS ETRACS Monthly Pay 2x Leveraged Closed-End Fund ETN (CEFL) and UBS ETRACS 2xLeveraged Long Wells Fargo Business Development Company ETN (BDCL) as diversifiers and for hedging possible macroeconomic outcomes. As I discussed in New Risks Appear For 2X-Leveraged mREITs, in November 2019, I added ETRACS Monthly Pay 2x Leveraged U.S. Small Cap High Dividend ETN (NYSEARCA:SMHD) The yield on SMHD usually exceeded both CEFL and BDCL and was only slightly less than MORL.

I took a small long position in SMHD based on the supposition that an interesting aspect of SMHD is that it may be diversifier for CEFL. This is because closed-end funds are excluded from SMHD. Originally, I looked at SMHD as a diversifier for MORL since SMHD has many equity issues that might do well in an environment of higher levels of economic activity. However, SMHD has a fairly large number of mREITs that are also in MORL. Since SMHD excludes closed-end funds there is no overlap with CEFL.

After UBS AG (UBS) created MRRL, which is essentially an identical twin to MORL, I bought some MRRL. For a short while, Fidelity allowed purchases of MRRL after they stopped allowing purchases of MORL and the other UBS 2x Leveraged High-Yield ETNs. In other brokerage accounts, I would buy either MORL or MRRL whichever was cheaper. Initially, trading was very thin in MRRL. This allowed MRRL to trade either above or below MORL for short periods, as it hit air pockets. There were a few times when the spread between MORL and MRRL approached $0.20 and I was able to switch back and forth between them.

Until September 6, 2018, MORL and MRRL usually traded very close to each other and to their net indicative (asset) value which is identical for both. The price relationship between MORL and MRRL changed after September 6, 2018. UBS then announced that they would no longer issue any new shares of MORL. While typically called "shares" ETNs are actually notes. The price of MRRL has continued to closely track net asset value since that announcement. However, MORL began trading far above MRRL (and the net asset value of both). The spread between MORL and MRRL eventually widened out to $0.97 on September 17, 2018.

This enormous spread prompted my article: Sell MORL, Buy MRRL which included:

..Just because MORL can possibly trade at a significant premium to net asset value does not mean that it should. This is especially true since the identical twin MRRL is still available at very close to net asset value. There may be some sort of a short-squeeze occurring in MORL. These are dangerous to participate in from either side. However, some short-term traders may want to get involved. For investors who own high yielding 2X leveraged ETNs for the very high current yields. If they are making a new purchase, MRRL is a better buy than MORL at present prices. Those that own MORL may want to take advantage of the historic spread and sell MORL and use the proceeds to buy MRRL...

The spread between MORL and MRRL narrowed dramatically soon after the article appeared on Seeking Alpha. The spread has bounced around since then, with MORL generally trading higher than MRRL, but until recently not approaching the spread levels seen on Friday, September 17, 2018, and on Monday, September 20, 2018, prior to the article appearing on Seeking Alpha. Chart I below shows the MORL - MRRL spread for the period after September 6, 2018.

Chart I

Generally, an investor now initiating or adding to a position in UBS ETRACS Monthly Pay 2X Leveraged Mortgage REIT ETNs either MORL or MRRL should buy whichever one is cheaper at the time. That has been MRRL for at least the last six months. Likewise, a seller, that owned both should sell the higher priced one. That has been MORL for at least the last six months. A trader trying to arbitrage the spread between might attempt to buy MORL when the spread was very close to the low end a range, with the hope of reversing into MRRL at some later date when the spread was higher.

Those investors that already own MORL, have a more complex situation. Any time one sells MORL and uses the proceeds to buy MRRL, they pick up yield and value as long as the price of MORL exceeds that of MRRL. However, they give up the opportunity of selling MORL at an even higher spread at a later date. One method of addressing the timing issue is basing the trades on the standard deviation of the spread. From the period September 6, 2018 through to April 22, 2019, shown on Chart I above, the average value of the MORL - MRRL spread was $0.387. The highest spread was $1.07 and the lowest -$0.11. The standard deviation was 0.314. If we assume that the spreads are normally distributed, then 95% of the time the spread should be within about 2 standard deviations from the mean. Thus, when the spread exceeds (2 x 0.314) + 0.387 = 1.05, it would appear an attractive point to sell MORL and use the proceeds to buy MRRL. Additionally, it would seem to be a good idea to not execute all of your position at one time as long as you have a large enough position that transaction costs are not a significant issue. Likewise, if your position is so large that executing all of you position at one time would result in only partial fills at various prices, it would also seem to be a good idea to not execute all of you position at one time.

The index upon which SMHD and SMHB are based has a fairly large number of mREITs that are also in MORL. While MORL and SMHB can trade significantly above their net indicative (asset) values. MRRL and SMHB cannot trade significantly above their net indicative (asset) values, as long as new notes are being created. This presents an opportunity for holders of MORL to switch into SMHB and pick-up yield and value. This may be of particular interest to those who hold MORL in accounts at Fidelity. Fidelity does not allow new purchases of MRRL, but it does allow new purchases of SMHB.

Trading between MORL and SMHB is risk arbitrage as opposed to the essentially riskless arbitrage involved in trading between MORL and MRRL or SMHD and SMHB. Since MORL and SMHB only have some but not all components in common, there will be drift between the two, separate from the relationship between MORL and its' net indicative (asset) values. The objective in trading out of MORL and SMHB, it to sell a note that is trading significantly above net indicative (asset) values and into ones that are priced very close to net indicative (asset) values. Arbitrage occurs when the two things being traded are similar and are expected to move similarly. Riskless arbitrage involves trading things that essentially identical such as MORL and MRRL. Risk arbitrage involves non-identical, but related things MORL and SMHB. There are various parameters that can be used to quantify the relationship between MORL and SMHB. One parameter is the difference between SMHB and MORL. That is shown below in Chart II

If you sold MORL on December 24, 2018 at$11.70 and bought SMHB at $16.98 for a difference of $5.28, you could have reversed it on January 2, 2019 when MORL closed at $!3.65 and SMHB at $21.92, a difference of $5.28. However, a substantial part of the increase in the SMHB - MORL spread could be attributed to the sharp increase in both SMHB and MORL over that period. To eliminate movement in the spread caused by changes in the magnitude of both, the spread could be divided by SMHB. That is shown below in Chart III.

Chart III suggests that the best time to have sold MORL and bought SMHB was on March 22, 2019 when the value of (SMHB - MORL)/ SMHB was only .273. On March 22, 2019 MORL closed at $14.78 a spread of $0.90 over MRRL which closed at $13.88. MORL's price was also $0.94 above the $13.84 net indicative (asset) value of MORL and MRRL. On that day SMHB's price of $20.33 was very close to the SMHB net indicative (asset) value of $29.28. Thus, selling MORL and buying SMHB, got you out of a UBS ETRACS Monthly Pay 2X Leveraged ETN that was selling at 6.8% above net indicative (asset) value and into one selling at only 0.2%. The one thing that is certain about the 2X Leveraged ETNs is that eventually they will be worth net indicative (asset) value. For the series: (SMHB - MORL)/ SMHB, the observed standard deviation is 0.0275 and the mean is 0.3276. Thus, the mean minus two standard deviations is 0.3276 - (2 x 0.0275) = 0.2726. That also suggests March 22, 2019 was a good day for selling MORL and buying SMHB.

Analysis Of The May 2019 MORL And MRRL Dividend Projection

My projected May 2019 MORL and MRRL monthly dividend of $0.1339 is a function of the calendar. Most of the MORL and MRRL components pay dividends quarterly, typically with ex-dates in the last month of the quarter and payment dates in the first month of the next quarter. The January, April, October and July "big month" MORL and MRRL dividends are much larger than the "small month" dividends paid in the other months. Thus, the $0.1339 MORL and MRRL dividend paid in May 2019 will be a "big month" dividend.

As can be seen in the table below, only four of the MORL and MRRL components - AGNC Investment Corp. (AGNC), Colony Credit Real Estate (CLNC), ARMOUR Residential REIT (ARR) and Dynex Capital Inc. (DX) - now pay dividends monthly. There are some of the quarterly payers that will, however, contribute to the May 2019 dividend. New Residential Investment Corp (NRZ) has an ex-date of 4/3/2019. Pennymac Mortgage Investment (PMT) has an ex-date of 4/12/2019. Arbor Realty Trust Inc (ABR) had an ex-date of 2/28/2019. Hannon Armstrong Sustainable Infrastructure Capital Inc (HASI) has an ex-date of 4/2/2019. Thus, those four quarterly payers will also contribute to the May 2019 dividend. That for quarterly payers will contribute to the May 2019 MORL and MRRL dividend, will make the May 2019 dividend the highest "small' month dividend since the $0.1371 November 2015 dividend. The table below shows the ticker, name, weight, dividend, and ex-date for all of the components. Additionally, the table includes the price and contribution to the dividend for the MORL and MRRL components that will contribute to the May 2019 dividend.

The VanEck Vectors Mortgage REIT Income ETF (MORT) is a fund that is based on the same index as MORL and MRRL. MORT pays dividends quarterly rather than monthly. As a fund, the dividend is discretionary by the fund management as long as it distributes the required percentage of taxable income to maintain its investment company status. Thus, it does not lend itself to dividend projections as an ETN like MORL or MRRL, which must pay dividends pursuant to an indenture.

Conclusions And Recommendations

MORL, MRRL and REML should play a larger role in 15%+ yield portfolios as the risk of the Federal Reserve raising interest rates in the near-term is substantially diminished. High-Yield junk bonds and preferred stock is more risky now because of the increased prevalence of bad-faith bankruptcies.

Various arbitrage opportunities exist in the 2x-leveraged ETN sector. There are two 2x-leveraged ETNs, MORL and SMHD that at times trade far above their respective net indicative (asset) values. Generally, new purchasers should avoid MORL and SMHD, in favor of MRRL and SHMB, 2X-leveraged monthly pay ETNs that are based on the same indexes as MORL and SMHD respectively. Holders of MORL and SMHD should consider when to switch to MRRL and SHMB. Selling MORL or SMHB and using the proceeds to buy MRRL and SHMB will usually result in an immediate increase in current yield. However, waiting for the spread to be even more favorable could be even more advantageous. This suggests that not switching your entire position at any one time may be a better course of action.

More sophisticated traders might try to trade both ways when the spreads deviate from the means by close to two standard deviations. Likewise, traders may want to play the spread between MORL and SMHB. as discussed in The Most Bullish Thing For A 2X Leveraged High-Yield ETN. Holders of 2x-leveraged ETNs have usually experienced a windfall when the sponsor ceases sales of newly created notes, and a twin 2X-leveraged ETN, based on the identical index exists. Holders of such 2x-leveraged ETNs should recognize that a potential windfall exists and consider what strategies they will employ to take advantage of the potential windfall. It should be kept in mind, that the windfall will disappear, if the old 2x-leveraged ETNs are held long enough, since at some point all 2x-leveraged ETNs will be only worth above their respective net indicative (asset) values. This will be when they are redeemed, either prior to maturity or at maturity.

On balance, I still tend to believe that the massive tax policy-induced increase in inequality will cause increasing excesses of loanable and investable funds, above commercially reasonable ways to utilize those funds. This will eventually result in an over-investment cycle with a recession, and that will ultimately be very good for the mREITs and 2X-Leveraged ETNs based on mREITs. However, there does exist now some possibility that there may be some reversal of the shift in the tax burden away from the rich and onto the middle class. This risk has arisen as a result of positions taken by some prominent Democrats advocating taxes on the very rich. There are other significant risks as well.

One consideration is that that it is unlikely that 2X Leveraged Mortgage REIT ETNs will pay their $25 face value at maturity. They will pay whatever the net indicative (asset) value is at the maturity date. That is not as scary as it might sound.

As is explained in "Applying Net Present Values And Internal Rates Of Return To 2X-Leveraged ETNs Yielding More Than 20%":

...That the net indicative (asset) value and dividends from a 2x Leveraged High-Yield ETN should be expected to decline over time can be a cause of concern or even scary. However, understanding that this is due to the fact that expenses and fees are deducted from the net indicative (asset) value of a 2x Leveraged High-Yield ETN, rather than the income, should alleviate some of the concern. Deducting the fees and expenses from income rather than principal would not impact the actual returns received from investing in 2x Leveraged High-Yield ETNs. The expected decline over time of the net indicative (asset) value and dividends is a consideration. However, once the magnitude of this factor is understood, it should not be much of an impediment to investing in these 2x Leveraged High-Yield ETNs...

Some large market participants may be able to profit easily from the spreads that are presenting arbitrage opportunities involving 2x leveraged high-yield ETNs. Brokerage firms that have hypothecated shares in their customers' accounts can usually short those shares and receive the proceeds of the short sale. It would be very profitable to short the higher priced 2x leveraged high-yield ETN and buy the lower priced one of the pair and just collect the difference in yield. Using the actual prices when Sell SMHD Yielding 21.5%, Buy SMHB Yielding 23.6%. was written, a firm that could short SMHD and simultaneously buy SMHB could collect 2.1% on the notational amount of the transaction indefinitely and also get a capital gain at maturity or when the prices eventually converged so that SMHB was equal to SMHD x 1.53. This would not require any outlay of cash if hypothecated shares were shorted.

The phenomena of the old 2x leveraged high-yield ETN trading significantly above its net indicative (asset) value, after new sales are suspended, while the new one trades very close to its net indicative (asset) value, means that the holders of the old 2x leveraged high-yield ETN can possibly receive a windfall when new sales of it are suspended. Thus, a consideration when choosing how much of any 2x leveraged high-yield ETN to own is the probability that sales might be suspended by the issuer at some point in the future.

One reason that sales might be suspended by the issuer, could be to allow its brokerage arm to generate essentially risk free income that would not require any outlay of cash, if hypothecated shares were shorted. I think it is likely that some customers of UBS might have hypothecated shares of 2x leveraged high-yield ETNs in their accounts. Paine Webber, a large retail brokerage firm, was acquired by UBS in 2000. See The Most Bullish Thing For A 2X Leveraged High-Yield ETN. For a discussion of why CEFL might be a candidate to have new sales suspended and a new version issued.

MORL And MRRL Components And Contributions To The Dividend

Name

Ticker

Weight (%)

Price

ex-div

dividend

frequency

contribution

Annaly Capital Management Inc

NLY

13.1

3/28/2019

0.3

q

American Capital Agency Corp

AGNC

9.17

18.08

4/29/2019

0.18

m

0.02527

New Residential Investment Corp

NRZ

6.78

16.71

4/3/2019

0.5

q

0.05616

Starwood Property Trust Inc

STWD

6

3/28/2019

0.48

q

Chimera Investment Corp

CIM

5.02

3/28/2019

0.5

q

Blackstone Mortgage Trust Inc

BXMT

5.01

3/28/2019

0.62

q

Two Harbors Investment Corp

TWO

4.86

3/28/2019

0.47

q

Colony Credit Real Estate Inc - A

CLNC

4.52

15.32

4/29/2019

0.145

m

0.01184

Invesco Mortgage Capital Inc

IVR

4.52

3/28/2019

0.45

q

Apollo Commercial Real Estat

ARI

4.51

3/28/2019

0.46

q

MFA Financial Inc

MFA

4.48

3/28/2019

0.2

q

Ladder Capital Corp

LADR

3.93

3/8/2019

0.34

q

Hannon Armstrong Sustainable Infrastructure Capital Inc

HASI

3.55

25.61

4/2/2019

0.335

q

0.01285

Pennymac Mortgage Investment

PMT

3.23

20.8

4/12/2019

0.47

q

0.0202

New York Mortgage Trust Inc

NYMT

3.04

3/28/2019

0.2

q

ARMOUR Residential REIT Inc

ARR

2.85

19.76

4/12/2019

0.19

m

0.00759

Arbor Realty Trust Inc

ABR

2.71

2/28/2019

0.27

q

Redwood Trust Inc

RWT

2.52

3/14/2019

0.3

q

Granite Point Mortgage Trust Inc

GPMT

2.24

3/29/2019

0.42

q

Capstead Mortgage Corp

CMO

1.44

3/28/2019

0.08

q

Tpg Re Finance Trust Inc

TRTX

1.4

3/28/2019

0.43

q

AG Mortgage Investment Trust Inc

MITT

1.36

3/28/2019

0.5

q

Western Asset Mortgage Capital Corp

WMC

1.35

3/29/2019

0.31

q

Kkr Real Estate Finance Trus

KREF

1.28

3/28/2019

0.43

q

Dynex Capital Inc

DX

1.15

3/21/2019

0.06

m

Disclosure: I am/we are long MORL, MRRL, REML, SMHB,CEFL, BDCL, AGNC, ARR, TWO, ARR. 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.