10/30/13

 Zenith Portfolio Strategies-12%-14% yield on Mortgage REITS

           We cited a tail risk with regard to mREITS  on our blog Oct 8th specifically with respect to the repo financing market. Here is the basic structure of an mREIT and a few more considerations before reaching for yield.

            An equity REIT actually buys the property or a real asset while a mortgage REIT buys Residential(RMBS) and Commercial mortgages(CMBS). They are buying bonds that are interest rate sensitive.

 Characteristics

  • They borrow short term via the repurchase agreement market(REPO) at rates that are currently very low due to the Fed anchoring short term rates near zero.
  • They use the borrowed funds(debt) to buy mortgage backed securities(debt) paying higher rates than the borrowed funds.
  • These are the mREITS assets.
  • This industry is currently structured in large part on funding costs(leverage) as low as they can go in order to buy (debt) whose interest rate sensitivity is very high due to low long term rates.
  • They earn the spread on this maneuver between short and long term rates.
  • They lose money when those bonds go down in value and gain when they go up in value.
  • They can hedge their book against a rise in rates but that is a cost that eats away at the spread they earn and can eliminate gains if rates go down so they need to be very, very adept at interest rate hedging.
  • This can be profitable in an increasing interest rate environment if they can hedge in a timely manner and then lift the hedge to participate in the larger spread due to new bonds having higher yields.
  • It can be a disaster if they do not hedge properly and they take a hit to book value and dividends need to be cut.
  • This disaster can be amplified if short term rates rise, increasing their funding costs and straining the REPO market that will be looking for their collateral.
  • In addition, these bonds in the RMBS and CMBS markets have credit risk as well.
  • For this investment to work out with a reasonable degree of confidence going forward a few pieces need to come into alignment.
  • The Federal Reserve needs to leave the Fed Funds rate low
  • Intermediate and long term rates need to remain stable over the foreseeable future.(May and June were not stable)
  • The mREITS need to have very capable hedging operations and solid mortgage backed credit and interest rate assessment teams.
  • REPO rates need to remain low and that market needs continued liquidity

            This is a very appealing yield that comes with a LOT of risk that can increase exponentially if the yield curve “cracks” and these mREITS are running for cover just to post collateral to their REPO desks.  

            Two ETFs in this space are down 24% and 21% from their highs this year back in Spring before the Fed shocked the yield curve by talking of Tapering asset purchases, driving the 10-yr Treasury significantly higher. That may be an appealing entry point although another yield shock would present a better one.

            We recommend a placement in this area only as a tactical placement especially if you utilize an ETF as there will a day that the favorable dynamics that have helped this sector deteriorate. While some are banking on a Fed Funds rate low until 2015, a stronger economy could potential raise that borrowing cost and an inflation surprise along with a Fed taper could send long rates much higher.

            Lastly, this position needs to be monitored as it is not a strategic long term holding for most investors as the risks are simply too high and too uncertain.

            In additional posts we will delve into the instruments available in this space and the ones we feel warrant the most attention from your investment committee.

Sincerely,

 Tom Koehler, CIO

 

 

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