by Neil Azous, Chief Investment Officer
Consistent with the themes laid out in our recent post “The New Narrative For Lower Interest Rates,” we believe that including assets that have positive carry in a portfolio will benefit from the Federal Reserve’s hiking cycle being over, and profit from the downward bias in yields over the next 12 to 18 months. One such asset is Mortgage REIT’s, or “mREIT’s.”
mREIT’s are a financing company that uses leverage – between 5 to 9 times – to purchases a basket of mortgage securities. Because of their high leverage, especially during Federal Reserve interest rate hiking cycles, mREIT’s use derivatives to hedge their interest rate risk.
Simply, an mREIT is a leveraged investment on the shape of the yield curve – that is, they borrow short and invest long. Because the positive spread is 1.25-1.50%, even with the inverted/flat yield curve currently, using ~7 times average leverage, the carry is upwards of 10%. When the yield curve steepens, the net spread that mREIT’s earn increases.
We believe two positive developments for mREIT’s are likely to materialize in the intermediate-term.
Firstly, when mREIT’s recognize that the Federal Reserve hiking cycle is over and the next move is an interest rate cut, they will likely lift portions of their interest rate hedges and run a positive duration gap1 – meaning they will be net long mortgage securities at ~7 times leverage. This will allow them to potentially reap the full potential of lower interest rates.
Secondly, when the Federal Reserve begins lowering interest rates, an mREIT’s cost of leverage will reset lower, which increases its net income spread. Over time, this will likely lead to a rise in dividends and contribute to an increase in book values.
Collectively, we believe that the potential for mREIT’s to generate a high amount of total return over the next year is significant. For a product with a historical volatility of ~13, the risk-adjusted return potential is one of the best in the public markets.
Opportunistic Entry Point
Firstly, the next Federal Reserve meeting is on March 20, 2019. The Fed is widely expected to leave interest rates unchanged. However, it will mark the first time in six quarters that the Fed did not raise interest rates. Passing this hurdle sets the stage for mREIT’s to potentially remove part of their hedges as the next step may be an interest rate cut.
Secondly, as a result of the credit markets locking up at the end of 2018, a key topic of interest on fourth-quarter earnings calls was the decline in mREIT book values. The source of this decline was the widening spread between three-month LIBOR and repo funding rates, which resulted in a negative earnings tailwind heading into this year as most interest rate swaps receive three-month LIBOR. Also, because of the speed and degree of the interest rate decline in December, fixed income volatility spiked, and the option-adjusted spread of mortgage bonds widened relative to US Treasuries.
Following the credit markets normalizing in the first quarter of this year and fixed income volatility subsiding to a record low, we expect this relationship to return to positively benefiting mREIT book values in the second quarter when they report earnings. Specifically, we believe that when companies announce their earnings that book values should reset higher by the high single digits.
We believe now is an entry point for mREIT’s that show up once per interest rate cycle – when the Fed transitions from a tightening to an easing bias.
Differentiation is Important
We believe differentiating between agency-focused and hybrid/credit mREIT’s is important.
Hybrid/credit mREIT’s have a higher beta to credit conditions. The bulk of credit spread widening in a cycle happens from the point when the Fed finishes raising interest rates until it is deep into a rate-cutting cycle. Why? Because that is when growth expectations are typically rolling over, and recession risks are rising fastest.
Therefore, agency-focused should be favored over hybrid/credit mREIT’s in this environment because they have a lower correlation to stock market weakness and credit spread widening.
Mortgage REIT’s Like Closed-End Funds
Like closed-end funds (CEFs), mREIT’s use leverage, have high distribution yields, and trade at a discount or premium to their book value.
Taking a similar tactical trading approach to mREIT’s that you do in the CEF market can potentially generate positive alpha over time if you are able to capture the change in share price relative to book value.
If you are interested in learning more about how we integrate mortgage REIT’s into a portfolio, please call us at 203-539-6067 or email us at firstname.lastname@example.org.
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Index Descriptions, Products, or Terminology:
- Duration: A measure of the sensitivity of the price – the value of principal – of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years.
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