The yield curve would likely win the award for the most watched and talked-about economic indicator in the last twelve months. Yes, it is compressed and flat. No, it does not mean a recession is coming. But that is a topic for another day. We do want to look at the yield curve though to try and figure out if the mortgage REIT exchange traded notes or ETNs are worth the risk in today's environment.
The current spread
The yield curve compression has been relentless and the current differential is minuscule compared to what we saw 3 years back.
This has made it very hard for mortgage REITs, and even banks for that matter, to make money by borrowing at the short end and lending at the long. As their business model has come under increasing pressure, the VanEck Vectors Mortgage REIT Income ETF (MORT) has lagged the broader market.
From a total return perspective, things do look better as the yield has made up for a lot of this difference.
While we examined the non-leveraged REIT ETF up until this point, the leveraged REITs have had a slightly different profile. UBS ETRACS Monthly Pay 2X Leveraged Mortgaged REIT ETN (MORL) and ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN Series B (MRRL) have outperformed the broader market as the large payouts have more than compensated for the price action.
While both these ETNs have held up well on a total return basis, their large dividends are likely to reduce substantially as the yield curve is not the only challenge the sector faces.
The headwinds do not stop with the yield curve
Mortgage REITs are currently facing two sets of headwinds. First, with the continuous yield compression, their spread income has been reduced. Second, the low 30-year yields have created no relief from high prepayments on mortgages. The latter is just picking up steam as bonds had an absolutely breathtaking rally in the last few weeks.
This will create more problems for many of the underlying holdings of MORL and MRRL.
While investors may see this as a known fact, we think there are still significant, more negative announcements to come over the next three to six months. We also expect more dividends to be chopped as companies come to grips with this new environment. The tightness of the spread alongside additional cost pressures is only going to be amplified as hedging costs rise. The sudden move in the long bond yield has made calls and puts significantly more expensive and this is likely to eat into what little profits are left for the mortgage REITs.
A key positive development
While 2018 will be remembered for the Fed backing off its rate hike promises, 2019 is likely going to test exactly how bad the environment can get within the space of just a few months.
Within a space of 8 months we have gone from pricing in 3.5 rate hikes over the next year to 3.5 rate cuts over the next year. This has to be one of the fastest changes on record. Should this materialize, we see some yield curve pressures backing off. However, the environment associated with these levels of rate cuts most likely will be one of general economic malaise and low bond yields. In this environment, mortgage REITs could see prepayment pressures well into next year.
Our overall assessment
The key theme for us is that while it is a very challenging environment and that part is well known, the extent of the impact on mortgage REIT income generation may not be fully synthesized by the market. With the 2X mortgage REITs, the large dividends act as "prepayments" against the original investment and serve to de-risk the investment. One more plus for investors is that as interest rates are lowered, the appeal of higher yielding mortgage REITs moves up and the market might pony up a higher premium for such assets. We give our mild bullish assessment to these notes based on that. However, looking deeper we see that there is only one real winner here.
MORL or MRRL
Whoever believes in perfect market efficiency should take a good hard look at these two ETNs. They are for practical purposes identical, yet MORL trades at an otherwise unheard of 7.62% premium to NAV.
Not only is there a premium, this premium is now at one of the highest levels that we have ever seen. MRRL on last check traded at a sweet 0.14% discount to its underlying NAV. We have never seen any situation where the choice between two similar exchange traded products was so biased towards one. Avoid MORL, Buy MRRL.
Alternatives for the non-leveraged mindset
Mortgage REITs employ tons of leverage and in some cases liabilities are more than ten-fold tangible equity. We understand that some investors may not want to add another 2X leverage on top of this. For those investors, we strongly recommend Annaly Capital Management, Inc. (NLY). While it yields significantly less than the 2X leveraged ETNs, the REIT has delivered good long-term returns while focusing on preserving book value. The current slight discount to book offers a decent entry point in our opinion. NLY currently yields 11.1%.
MORL and MRRL have to be analyzed in a macro context rather than as yield-plays. The current yield is but one factor we look at. We think even if the Fed delivers the rate cuts, many more dividends will likely be chopped in the next 12 months in this sector. However, the 2X structure with large cash flows makes them particularly interesting as the total loss potential actually decreases. The notes are exchange traded notes and are the liability of UBS (UBS) and that can impact its pricing. On our scale of 1-10, where 1 would be "Avoid like the bubonic plague" and 10 would be "Buy like this is Apple (NASDAQ:AAPL) in March 2009," we would rate MRRL a Buy and at 6.0.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MRRL over the next 72 hours. 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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TIPRANKS: BUY MRRL