- DMO is a leveraged CEF invested in mortgage backed securities, in both the residential and commercial sectors.
- The fund has a slight discount to NAV and an attractive yield, so it does look tempting here.
- The current yield will benefit from rising rates, especially as it limits refinancing activity.
- However, a majority of DMO's holdings are below investment grade and/or non-rated. This makes it hard to identify the true credit risk of the fund.
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The purpose of this article is to evaluate the Western Asset Mortgage Defined Opportunity Fund (NYSE:DMO) as an investment option at its current market price. This is a fund I have my eye on, and I may initiate a position in it in the near future. I like the residential and commercial MBS exposure, as I see a solid background for both those sectors. Property values are rising, in residential homes and commercial properties, save in the retail sector, and this is supporting underlying bond prices. Further, with a recent increase in yields, refinancing activity has been on the decline, which helps to support the current income production for the fund.
However, there are some downsides as well. Despite trading at a discount, DMO is slightly more expensive than its 1-year average. Further, the fund has seen a distribution cut recently, and 2021 section 19 notices indicate there could be another cut on the cards. While declining refinancing activity helps, that may not be enough to prevent another cut. Finally, while I find the fund's underlying sectors attractive, I do not like how the majority of the debt on the books is not rated. This makes judging credit quality difficult.
First, a little about DMO. It is a closed-end fund with a primary objective to provide "a leveraged portfolio, consisting primarily of non-agency residential mortgage-backed securities, commercial mortgage-backed securities, and mortgage whole loans." Currently, the fund trades at $14.64/share and pays a monthly distribution of $.1125/share, yielding 9.28% annually. This is my first review of DMO, and has come about as I am working on being creative with my new asset purchases in the new year. With valuations rising for the S&P 500, I continue to search for relative value, and have done so by branching into under-represented equity sectors, gold, Bitcoin, and managed duration bond funds. To diversify further, DMO has come on my radar screen, as a way to play the MBS asset class. After taking a look at this fund, I see both positive and negative attributes, which I will discuss in detail below.
Positives in the Residential MBS Sector
To begin with, I will discuss my outlook for the residential MBS sector, as that is DMO's biggest sector by weighting. In fact, the fund is almost exclusively invested in MBS, with heavy weightings in both residential and commercial MBS, as illustrated below:
Source: Franklin Templeton
Importantly, this is an area I have been bullish on for a long time, and remain so today. My primarily vehicle for MBS investment is through the BlackRock Income Trust (BKT). However, rather than adding to that fund, which I already have a sizable position in, I am considering DMO. This is because, despite both having MBS exposure, DMO is a bit different in what it offers. While BKT holds agency residential MBS, DMO holds mainly non-agency MBS, in both residential and commercial sectors. This is not better or worse, but simply different, as it allows investors to obtain a higher income stream, while simultaneously taking on more risk. Whether this is the right move is an individual call.
With that in mind, there are a few macro-developments in the residential MBS world that make me bullish on the sector, in both agency and non-agency. Therefore, I don't see an inherent problem in going down in credit quality in this area at the moment. One reason is that, as longer-term yields have risen, so have mortgage rates. While rates still remain low by historical standards, we have not seen increases in a while, so it is a significant development. This impacts DMO, and other funds that hold residential MBS, because it should limit refinancing activity over the next few months. In fact, refinancing applications have already seen a sharp drop in the short term due to the rise in rates, as illustrated below:
This is relevant to investors in MBS because it helps to maintain current income streams. For example, DMO will see its current income pressured if mortgage holders refinance their current mortgages at lower rates. While investors in DMO will benefit from being paid back at par value on the mortgage, the income stream will take a hit, assuming the fund has to replace that refinanced mortgage with a new one at the prevailing, lower rate. This has been occurring at a fast pace over the past year, pressuring the income generation of the fund. In fact, this activity is partly responsible for DMO's income cut back in September last year, shown below:
Source: Franklin Templeton
The point here is that refinancing has taken a major toll on income streams, in both MBS and in the broader fixed-income market. Now, with yields and rates ticking higher, refinancing activity has come down. This will help make DMO's income stream more sustainable, which is a positive for investors.
A second positive development in the residential agency MBS space is that new home sales have started to stabilize. While not necessarily "good" for the housing market as a whole, I see this as a short-term positive for DMO investors because it helps limit the supply of new MBS hitting the market. If demand for these assets stays high, then the drop in supply should support underlying values of the bonds. Importantly, the decline in new home sales has been accelerating in the past few months, as shown below:
Source: Yahoo Finance
The third positive development has been a multi-year trend that has continued uninterrupted in 2021. This is rising home property values, which have been consistently trending higher due to a recovering economy, low interest rates, and a surge in interest in home ownership, as detailed below:
Source: St. Louis Fed
This is an especially important point, and is one that supports my interest in the non-agency realm of residential MBS. The reason being, as home values rise, those homeowners have a greater incentive to make good on their mortgage obligations. Further, even if a forced sale occurs because of foreclosure, there is a better chance the investor will be made whole if the bank or lender can sell-off the property at a higher value than the original loan amount. Ultimately, rising home values provide a cushion for MBS investors. In this environment, which is what we have seen over the past decade, moving down the credit ladder is not as risky. Therefore, I do not feel the need to avoid non-agency MBS, which is why I am keeping an eye on DMO.
Commercial Property Values Have Been Resilient
I will now shift the focus to the commercial MBS sector, which, as I noted, is also very important to DMO's overall performance. Similar to the residential MBS sector, I see rising yields and rates as a positive for current shareholders of DMO, as it will limit refinancing in this sector also. So the first point discussed in the preceding paragraph is also a positive catalyst here as well.
Additionally, commercial property values have also been quite resilient. Despite intuitive sense, many commercial properties continued to increase in price throughout the Covid-19 pandemic. While retail was a notable laggard, and office properties also saw some temporary weakness, industrial and apartment values more than made up for it. In fact, as measured by the All Property Index, property values have been increasing near levels we saw pre-pandemic, on a month over month basis:
Source: Real Capital Analytics
This illustration is a reiteration of the same point I made above for residential MBS. Rising property values help to stave off foreclosure, and also elevate the probability of a profit even during a distress sale. Simply, despite all the challenges we are seeing in the market, commercial MBS investing remains a profitable play.
One of the reasons behind that reality is the third positive point, that there is a lot of cash on the sidelines. As private equity investors look for commercial properties, they are finding many owners are reluctant to sell. Despite predictions of a wave of foreclosures, rising values and government support have limited the need for landlords to liquidate. Adding to this mix is the strong desire among investors to increase their commercial real estate exposure. In fact, there is more cash on the sidelines now waiting to be deployed in commercial property deals than at any point in the last decade:
Source: Yahoo Finance
The overall takeaway here is commercial MBS is not an under-performing asset class, even with a global pandemic. Interest in commercial properties is extremely high, and this is pushing property values up and keeping defaults down. For investors in DMO, this is a good backdrop.
Has A Discount, But Valuation Is At 1-Year Average
So far, I have painted a pretty positive story for DMO. But those points have related mainly to broader points about the underlying sectors the fund holds, and not micro-points about the fund itself. Diving deeper into the fund, there are a few points that make me a little cautious. One in particular is valuation, which is a fairly positive point on the surface. In fact, DMO currently sits in discount territory, with a market price roughly 2% less than the fund's NAV:
Source: Franklin Templeton
To be fair, this does mean investors are getting some value here, and I do like to buy CEFs at a discount. Still, I am not wildly bullish on buying at these levels. A reason for this is that DMO often trades at a discount, especially in the short term. Sure, the fund has traded at sustained premiums as well, which makes buying at a discount now seem attractive. But if we look at the past trading year, we see there have been many instances where investors could have bought it at a wider discount:
Source: Franklin Templeton
My point here is simply to manage expectations. Yes, the discount is preferable to a premium, and DMO certainly has proven it can trade at premium prices. But investors should also realize the current discount is actually more expensive than the fund's 52-week average, albeit only slightly. This tells me that patient investors may be able to get a better price than the current one, and suggests the current discount is not much of a deal.
Non-Rated Debt Does Pose A Concern
My next point concerns the underlying credit ratings for DMO. While I spent a good deal of time in this review highlighting why I like the fund's assets, I must again balance out this optimism. I do not expect widespread defaults in either MBS space, but I will emphasize this is not a "risk-free" fund. In particular, one of the factors I do not like about the fund is the fact that most of its debt is not rated, as shown below:
Source: Franklin Templeton
My takeaway here is I do not appreciate the lack of transparency when it comes to the credit quality of these holdings. The fund is being transparent by declaring most of the debt is non-agency, and in listing out the ratings of its holdings. But many of the actual bonds and loans in the portfolio have not been independently rated, and that is a concern. As a result, it makes it hard to judge the true credit risk of this product. Therefore, it poses a challenge, especially to more conservative investors, when deciding if this is the right CEF for them.
Income Story Not All Positive
My final point looks at the fund's distribution. This should be top of mind for all DMO investors, since the fund has recently seen an income cut. Fortunately, I see some of this income pressure being relieved in the next few months, driven by the slowing refinancing activity I mentioned in the preceding paragraphs. However, even with an adjusted distribution, the fund may still struggle to pay out the current rate. To see why, consider that almost 1/3 of the distribution was Return of Capital, as noted in the March Section 19 notice:
Source: Franklin Templeton
The conclusion here may be that DMO has not seen its last distribution cut. The fund's income stream is still under pressure because refinancings, while dropping, are still a big chuck of mortgage activity. Further, even though the distribution was cut back in September, it clearly was not big enough a cut to match actual earnings. Fortunately, the fund has already declared its May and June distributions, so there is not an immediate risk of a cut. But this is something investors need to watch very closely in the year ahead.
DMO is one of the few CEFs offering investors direct, leveraged residential and commercial MBS exposure. This is an area I am looking to add to in my portfolio, so DMO will be top of mind over the next few weeks. While I own agency MBS through BKT, I like DMO's higher yield, larger discount, and commercial holdings, and see it balancing out my portfolio a bit.
However, a few points make me hesitant. One, the fund often trades at a larger discount, so being patient may be advantageous. Two, the fund's income stream is clearly not supporting the current distribution level. Thus, waiting for a future cut, and buying in after the likely corresponding sell-off, could also be the right move. Three, the fund's non-rated assets make judging the overall quality of the portfolio difficult. Since I see elevated risks in the equity market, I may not want elevated credit risk in my debt holdings as well. Therefore, I believe a neutral rating on DMO makes sense at this time, and I would suggest investors approach new positions selectively.
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This article was written by
I've been in the Financial Services sector since 2008, which gives me an invaluable insight in how markets can turn. I currently work for a large-cap US Bank in funds management. I was a D1 athlete in college (men's tennis) when I got my Finance degree. I received my MBA in 2013 in North Carolina.
My readers/followers can trust that I won't pump any investment nor discuss a topic I don't genuinely follow and research. In that spirit, I list my portfolio here for transparency
Broad market: VOO; DIA, RSP
Utilities: VPU, BUI
Energy: VDE, RYE, IXC
Innovation: GINN, QQQ
Non-US: EWC; EWU; EIRL
Dividends: DGRO; SDY, SCHD
Municipals/Debt Funds: BGT, Individual muni issues (NC)
Stocks: WMT, JPM, MAA, SWBI, MCD, WM, MGM
Cash position: 25%
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DMO 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.
I am long BKT
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