by Ivan Martchev | January 31, 2013 7:00 am
When I was asked to comment on the relentless rally of Newcastle Investment (NYSE:NCT), I had to look up the name. It was not a company I follow, and I immediately found out why — it was a mortgage REIT.
Having observed the failure of Thornburg Mortgage in 2008, I concluded back then that only a true bond guru can have an idea what goes on in a highly leveraged structure like an mREIT.
So I looked one up.
Mike Lanier is a familiar bond expert that has traded billions of dollars worth of corporate bonds, including for some of the country’s largest financial institutions.
“I am a corporate bond guy,” Mike told me, “which is a very different game than managing mortgage bonds. With that caveat, I can tell you what a corporate bond guy thinks about mortgage bonds.”
“Sure,” I said. Knowing the bond market is vastly larger and more diverse than the stock market — every bond issue has its own covenants and fine intricacies — I still needed to hear the opinion of a bond expert.
“The Federal Reserve has massively compressed spreads between Treasuries, mortgages, and riskier corporate bonds,” Mike explained. (After the December Fed meeting, the FOMC stated it will continue the $40 billion per month purchases of mortgage-backed securities and $45 billion per month of Treasury security buying.) “This, in my opinion, has had a much bigger impact on mortgage pools than on actual properties.”
His point on mortgages vs. properties is significant. A normal REIT would buy properties, then the REIT management would continuously improve the property portfolio to maximize cash flow by keeping prime properties and divesting not-so-desirable ones.
“Now that is a real real estate business,” Mike told me.
He had traded a lot of general obligation REIT bonds — which are much more like corporate bonds than mortgage bonds — and he generally had a favorable view on those.
“In many cases, general obligation REIT bonds were safer than general corporate bonds with the same rating as there was more protection guarantees in their covenants. General obligation REIT bonds have a leverage test covenant, which prevents REIT management to borrow in a way that would risk the repayment of the interest and principal on the bond. Typically, most corporate bonds do not have that protection.”
But the market quickly did away with that opportunity and bid up general obligation REIT bonds to prices that made them too expensive to buy at present. I told Mike that typical REIT shares also have dividend yields near all-time lows, similar to their expensive general obligation bonds. For instance, Simon Property Group (NYSE:SPG) — the nation’s largest shopping mall operator — now has a forward yield of 2.8% compared with a five-year average of 3.5%.
As the discussion went on, it became clear that a mortgage REIT is a REIT in name only, using the tax-favorable treatment of cash flows, as it was a purely financial structure that lent money into the residential and commercial real estate lending markets — it did not own or manage any properties directly. Mortgage REITs and normal REITs employ different types of people. There also are hybrid REITs that do both activities, but by and large, those are separate businesses.
“A mortgage REIT is like a fund-of-funds, only for mortgage-backed bonds.” They basically are a vehicle for a carry trade. As long as the yield curve is steep — short-term interest rates are much lower than long-term interest rates — their cost of funding is lower than the yields on the MBS they buy.
MREITs raise money via either debt or equity, then they buy MBS, then — and here it gets interesting — they repo* those securities to a bank to get money to buy more MBS, then keep continuing the cycle.
This relentless repo-ing allows aggressive buildup of MBS of various kinds — there also are those that are not guaranteed by the U.S. government — which makes a mortgage REIT a highly leveraged structure. What type of MBS it buys and how much leverage it uses could be the difference between a profit and a loss.
“In the end,” Mike explained, ”you have to keep in mind that what you see in the quarterly filings is the snapshot of the portfolio at the end of the quarter. I used to run a corporate bond fund, and I can tell you that a lot of changes in holdings can happen in a bond portfolio between two quarterly snapshots. So when buying mortgage REITs, what you are really buying is the MBS expertise of the mortgage REIT managers.”
I told Mike that one of the more conservative mortgage REITs known for less leverage and preference for higher-quality MBS over the years — Annaly Capital Management (NYSE:NLY) — has a forward dividend yield of 12.2% and a five-year average yield of 13.8%.
“In the second week of January, CCC-rated corporate bonds dipped below 10%, and they rarely do that. What does that tell you about risk and reward?” Mike said.
He did not have to explain more. Considering all of the above, I concluded that anyone considering investing in a mortgage REIT needs to examine carefully their leverage ratios, as well as what type of MBS they buy. And if a lower dividend yield is the price to pay for safety, maybe that is the way to go. Or, at least consider the only pure mortgage REIT ETF that diversifies many managerial issues that may arise with single mortgage REITS: the Market Vectors Mortgage REIT Income ETF (NYSE:MORT).
* “Repo-ing” MBS is entering a repurchase agreement where the MBS is collateral for a loan that a major financial institution makes to a mortgage REIT. If something goes wrong with the loan, the bank can keep the MBS, even though in cases with guaranteed MBS like Fannie and Freddie paper somehow has to go wrong with Uncle Sam before that repo financing is gone. Repo rates are correlated to short-term interest rates controlled by the Federal Reserve.
Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own. Navellier & Associates does not hold positions in any securities mentioned in this article for its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the aforementioned securities.
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