Description

While mortgage REITs (mREITs) are typically treated with disdain by most sophisticated value investors, the sector tends to offer very good trading and investment opportunities immediately following disruptions in the fixed income markets.  In fact, the better managed mREITs have actually delivered extremely competitive risk-adjusted returns with low correlation to the broad equity indices over multi-year holding periods.  

My last mREIT recommendation was MFA Financial, written shortly after the taper tantrum in the middle of 2013.  Please refer to that writeup for more introductory information on mREITs, their use of leverage, their hedging techniques, the difference between Hybrid and Agency mREITS, etc.  Then, as now, a double discount opportunity was offered in the sector as volatility in the treasury market cheapened the underlying assets in their portfolios and the securities themselves moved to big discounts to their NAVs.  

Today I am recommending Anworth Mortgage (ANH) for the following reasons:

• it trades at a large discount to book value (market price is 81% of last quarter’s reported tangible book and my guess is that book value has increased since then);

• it pays a very attractive attractive yield (11.5%, which is supported by core earnings);

• its assets are relatively low risk;

• its management team has an exceptional track record; and, most importantly,

• the company is actively buying back its stock to take advantage of the discount offered by the market.

Despite the fact that I am offering up a single name, I do think many others in the sector are also very interesting. This writeup includes a pretty comprehensive comparables analysis that I think some VIC members will find useful in selecting other securities in the sector depending on one’s view on interest rate and/or credit trends.

Global fixed income markets have been roiled by major dislocations throughout 2015.  Within the United States, the yield on the benchmark 10 year treasury note had risen by over 50% from a low of 1.64% in late January to almost 2.5% in mid-June.  Rate volatility is the bane of the mortgage investor, particularly for the managers of Agency-focused mREITs due to the fact that they are hedging negatively convex assets against these interest rate movements and are therefore forced to buy back back their hedge instruments as prices rise and reset hedges as prices fall to manage the rate exposure of their portfolios.  By the end of June, the mortgage market was hit both by the rise in their benchmark treasury yields and by the widening of their spreads to these benchmarks.  As the mostly retail investor base fled the sector, discounts to book widened even as book values fell.  Despite a partial recovery in the prices of their underlying assets, historically large discounts persist to the June quarter end marks in the sector.

The table below summarizes the book value discounts for most of the larger, more liquid  mREITs.  I separate the mREIT sector into two classes:  Hybrid and Agency.  The Hybrid mREITs diversified into more credit sensitive securities and loans in the aftermath of the financial crisis.  Whereas the assets of the Agency mREITs have virtually no credit risk due to an implicit federal guarantee of the government sponsored issuer backing the highly liquid securities they own, they face prepayment risk because their assets are held at significant premiums to par (usually 104% of face or above) and yet can be prepaid at par.  Further, the Agency mREITs must take on more leverage because their assets have very low yields.  

The Hybrid mREITs benefit from holding higher yielding assets and thus require less leverage.  Prepayments on some classes of their holdings are also usually a positive event because the securities are often held at discounts to par.  The Hybrids are so called because they also allocate a portion of their capital to the Agency strategy.  

In my view, the larger the percentage of an mREIT’s equity devoted to the Nonagency strategy the better.  I believe we are still far from the peak in housing prices and so credit instruments backed by residential real estate should continue to do well.  By contrast, the rate volatility that comes with the normalization of the Fed Funds Rate will likely continue to create headwinds against the book values of Agency mREITs.

Market Cap, Strategy Category, and Price to Book

The Agency mREITs currently trade at larger discounts to book on average.  Interestingly, Anworth has historically been an Agency mREIT but is now transitioning to the Hybrid model.  As shown above, 30% of its equity is devoted to Nonagency product.  Investors therefore prospectively will enjoy the benefits of the Hybrid model but can purchase the security today at the pure Agency discount to book.

Most retail investors own mREITs for the dividend yield, but not all mREITs actually earn these dividends.  When an mREIT pays dividends in excess of income it is effectively liquidating.  Of course, liquidation when a security trades at a large discount to book value is not necessarily a bad thing from a sophisticated investor’s perspective.  Nonetheless, when dividends are not supported by income, they inevitably get cut which almost always trigger a retail exodus and a selloff in the name, so my preference is to own the ones whose income yield at least equals its dividend yield.

Income Yield, Dividend Yield, and Coverage

As shown above, TWO, AGNC, ARR, and CMO did not cover their dividends with core earnings last quarter.  Further, MFA, TWO, and CMO have relatively low core income yields when compared to their comparables.  On the other hand, AMTG, MITT, ARR and NLY may have unsustainably high income yields relative to comparables.  The riskiness of the portfolios, hedge effectiveness and other risk characteristics need to be assessed to determine the extent to which book value might decline in an adverse environment.

The table below highlights the embedded leverage for each mREIT, as well as the percentage hit sustained in book value during the difficult June quarter and the prospective impact of a 50 bp rise in interest rates reported in their latest 10-Qs.

Effective Leverage, Last Quarter’s Book Value Decline, and 50 bp Rate Shock Risk

As the table above shows, even though the Hybrids have less leverage, they were only slightly less vulnerable to book value erosion from the rise in rates last quarter.  Anworth held up the best among all of these.  Note around 3% in dividends were paid during the quarter so the negative total return generated during this highly disruptive period was not as severe, and in Anworth’s case total returns were positive.  Outside of the 30% Nonagency holdings, Anworth’s assets are predominantly adjustable rate mortgages (ARMs) that are in or near their reset periods and thus have very low duration.  For this reason, leverage is perhaps not the most appropriate measure of risk for that name.

Another way of evaluating management skill, risk, and return potential is to look at IRRs over longer periods.  I computed the total return of each name from the beginning of 2012 though the August 14, 2015 and I found the results somewhat surprising given the recent dramatic selloff in the group.  Further, if I neutralize the market’s current opinion on these names by adjusting the total return calculation to use the last reported book value for each name instead of the market prices we can see what I think is a fairer report card on what management has achieved over the last three and a half years.  Note that the start date for this calculation was completely arbitrary.  I wanted to go back as far as possible and include the impact of the 2013 taper tantrum but I also wanted to make sure the start date was at least six months after the inception date for all the names on the list.

Annualized IRR and Adjusted Annualized IRR from 12/31/11 through 8/14/15

Note that the average adjusted IRR for the Hybrid mREITs actually exceeded the IRR for the S&P 500 depositary receipts over this massive breakout period for that index.  Anworth’s almost 12% IRR over this period is also impressive given the relative riskiness of the assets in its portfolio.

One of the most important measures of management quality in my view is a demonstrated willingness to take advantage of extreme mispricings in the issuer’s own stock to maximize shareholder return.  As VIC members know, managers of mREITs and BDCs offer up many excuses for refusing to execute buybacks even when their securities are trading at massive discounts.  The most common monologue I have heard is a discussion of scale and how shareholders benefit from a larger equity base due to spreading of fixed costs, liquidity, market presence, etc.  While these arguments have some validity, the reality is that these managers are making the decision to invest cash in assets yielding between 2% (for ARMs) and 7% (for risky, discounted Nonagencies) on a daily basis when the market is offering them an instantaneous return of 20% or more on the asset they should understand the best - their own stock.  Here the conflicts of interest between management and shareholders are most visible, and the managers’ interest usually wins out because for them it can be an existential issue - they ultimately could liquidate the company and buyback their way out of a very good job.  I therefore view a willingness to execute (NOT merely announce) a buyback in this space as a tremendous indicator of management’s commitment to shareholders as well as to optimal capital allocation.  The table below presents the annualized rate at which each name repurchased its own stock as a percentage of its market cap over the most recent quarter.

Annualized Buyback Rate as Percentage of Market Cap during Q2 2015

Here again, Anworth’s management shows its skill and shareholder commitment.  While their buyback pace tapered off during July, management made it very clear on the conference call that they continually look for the very best place to invest their cashflow and their own stock is just another asset to choose from.  The texture of CEO Lloyd McAdams’  comments suggest that a 20% discount to book is the threshold where the gloves come off as far a the buyback is concerned.

Conclusion

While the mREIT space as a whole may deserve some of the disdain offered by its detractors, many names have achieved attractive investment returns that are competitive with equities.  Careful security selection in the space during times like now, when names in the sector are generally trading at substantial discounts to tangible book value, will likely achieve attractive, uncorrelated total returns over a multi-year holding period.  I am recommending Anworth based on its large discount to book, which I believe is unwarranted given the low risk level of its assets and the quality of its management team.  Further, with the 11.5% yield you are paid to wait until the discount closes.  I estimate a likely 30% return over the next 12 months as the discount collapses on the security and its yield is collected.

I also like AMTG and MTGE, though the lack of a buyback is concerning to me given their substantial discounts.  I would be a buyer of AGNC, TWO, or MFA at larger discounts.  While I admire the fact that ARR and CYS are currently buying back stock and that ARR in particular trades at a massive discount, my concerns about risk management for these names make them less tempting.  I do think though that traders who wish to position for an interest rate decline could “rent” these and have good short term results.

Catalyst

Time to collect interest and close discount.  Continued movement toward Hybrid mREIT model.  Continued buyback.