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 info@rareviewcapital.com.
Disclaimer
This material is for informational purposes only and does not constitute an offer or a solicitation to buy, hold, or sell an interest in any investment or any other security, including any investment with Rareview Capital LLC (“RVC”) or any of its affiliates or any other related investment advisory services. This material is not designed to cover every aspect of the relevant markets and is not intended to be used as a general guide to investing or as a source of any specific investment recommendation. This material does not constitute legal, tax, or investment advice, nor is it a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. In preparing this material, RVC has relied upon data supplied by third parties. RVC does not undertake any obligation to update the information contained herein in light of later circumstances or events. RVC does not represent the information herein is accurate, true or complete, makes no warranty, express or implied, regarding the information herein, and shall not be liable for any losses, damages, costs or expenses relating to its adequacy, accuracy, truth, completeness or use. This material is subject to a more complete description and does not contain all of the information necessary to make any investment decision, including, but not limited to, the risks, fees and investment strategies of an investment. All investments carry a certain degree of risk, including the possible loss of principal. There is no assurance that an investment will provide positive performance over any period of time. There are specific risks that apply to investment strategies. Closed-end funds frequently trade at a discount to their net asset value. These risks should be reviewed carefully before taking any investment action. Since no one investment style or manager is suitable for all types of investors, this site is provided for informational purposes only. The statements contained herein are the opinions of RVC. This site contains no investment advice or recommendations. Individual investor results will vary. Rareview Capital LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing. Past performance is no guarantee of future results.
Futures trading contains substantial risk of loss and is not suitable for every investor. An investor could potentially lose all or more than their initial investment. Risk capital is money that can be lost without jeopardizing ones financial security or lifestyle. Only risk capital should be used for trading and only those with sufficient risk capital should consider trading. Past performance is not necessarily indicative of future results. In light of the risks, you should undertake such transactions only if you understand the nature of the contracts (and contractual relationships) into which you are entering and the extent of your exposure to risk. Trading in futures and options is not suitable for many members of the public. You should carefully consider whether trading is appropriate for you in light of your experience, objectives, financial resources and other relevant circumstances.
Prior to buying or selling an option, investors must read a copy of the Characteristics & Risks of Standardized Options, also known as the options disclosure document (ODD). It explains the characteristics and risks of exchange traded options. Copies are available by calling 1-888-OPTIONS, or from The Options Clearing Corporation at www.theocc.com.
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.
- ¹Duration Gap: The difference in the price sensitivity of interest-yielding assets and the price sensitivity of liabilities (of the organization) to a change in market interest rates (yields).