Oversold mortgage REIT priorities ignore household resilience

Darren 415

This article was first released to Systematic Income subscribers and free trials on October 25.

This article focuses on the hybrid mortgage REIT preferred sector with a focus on non-agency mortgage securities.Book values ​​of hybrid mREITs continue to outperform agencies Partly due to household resilience. However, this strength is not reflected in their priority performance below agency priorities. This article explains some of the reasons why this book value outperforms and discusses his double-digit yield opportunity in this sector.

Families stay resilient

Bank earnings provide a good matching indicator of household health. Overall, there are no signs that households are struggling or the health of the sector is declining.

JP Morgan’s CFO said:

I don’t see any cracks that you could realistically describe in any of our actual credit performance. . . we’ve done a pretty detailed analysis of different cohorts and early delinquency bucket entry rates, etc. And in some cases, we see slight increases. But in general, in almost all cases, I believe it’s normalization, and it’s even slower than expected.

Wells Fargo CEO added:

deposit balance [retail] Accounts were down from Q2, but still higher than a year ago and above pre-pandemic levels. However, we continue to monitor segment activity closely for signs of potential stress and for specific customer cohorts. Average balances have fallen steadily and are now below pre-pandemic levels, and debit card spending continues to decline. . . However, it is important to note that this represents only a small percentage of our overall customer base. Overall, consumer deposit customer health indicators such as cash flow, salaries and overdraft trends still do not indicate heightened risk concerns. Debit card spending is well above pre-pandemic levels. Credit card spending remained strong in the third quarter, up 25% year-over-year, with all spending categories seeing he saw double-digit gains.

Healthy household balance sheets and low debt service levels have supported households through a decelerating macro environment. This resilience is also largely explained by accumulated savings through August exceeding the pre-COVID trend of about $1.3 trillion, or about 8% of annual consumer spending, according to Wells Fargo. If the reduction continues at this rate, it will take another 15 months to exhaust this stockpile.

wells fargo

wells fargo

The amount of outstanding revolving credits also increased sharply, but remains 5% below pre-pandemic trends. Moreover, household debt service as a percentage of disposable income remains low. Overall, much of the typical debt profile is typically driven by fixed-rate mortgages, making consumers less sensitive to rising interest rates.

wells fargo

wells fargo

Book value of hybrid mREITs is far from falling off a cliff

While the third quarter earnings season hasn’t fully started yet, six mortgage REITs have provided guidance on NAVs for the third quarter, with three in the agency subsector (ARR, NLY, AGNC), Three are in hybrid subsectors (MFA, EFC, MITT). ). A key takeaway is that the hybrid subsector continues to be more resilient to the broader impact in the mortgage sector. The chart below compares book value trends for these two subsets over the past year.

systematic income

systematic income

The book value outperformance of the hybrid mREIT subsector is primarily due to 1) the de-leveraging of hybrid mREITs and 2) the fact that the household sector is still doing well. Much less liquid than agency MBS, especially now with much less leverage via mark-to-market functions, making negative feedback loops such as margin calls, bargains, price cuts and increased margin calls less likely. increase. 4) High interest rate volatility reduces the impact of interest rate hedging. 5) The drain on the Fed’s balance sheet directly affects only the Treasury and government agencies, not the overall loan.

Interestingly, however, this year’s book value gains in the hybrid subsector have not been rewarded with stronger returns. The chart below shows year-to-date total returns for mREIT preferred sectors. Blue bars indicate hybrid preference and red bars indicate agency preference. Horizontal lines indicate mean values ​​for the two subsectors. The average hybrid mREIT priority is 6% lower than the average agency priority.

systematic income

systematic income

Part of this outperformance is AGCNN and NLY.PF Both have switched to floating rate coupons, increasing yields by 2-3% in the process, which is supporting prices. However, even excluding these two of his preferences, agencies still outperform in his subsector.

The market seems to be trading the sector in terms of ‘less secure/more secure’, with agency mREITs being perceived as ‘more secure’, which is an advantage. In our view, this is not the right way to approach the sector and the book value trajectory of both subsectors this year clearly demonstrates this.

our recommendation

Our approach to mREIT preferred investing focuses on a number of key fundamental metrics. These include the level of leverage (specifically with a focus on recourse leverage), the level of agency within the portfolio, the volume of mark-to-market leveraged products, and the level of equity/preferred coverage.

All else being equal, we will focus on mREITs with lower levels of leverage, higher levels of agency, higher levels of equity/priority coverage, and lower levels of mark-to-market financing. Most of these are self-explanatory. Allocations to agencies are always attractive. This is because agencies are liquid even in tough market conditions and can be used to raise cash for margin calls.

We combine these three basic metrics to stress test, using agency, whole loan, MSR, and other securities drawdowns to stress the book value of a specific mREIT. Needless to say, we are overweight companies with higher levels of stressed equity/preferred coverage.

In addition to the underlying situation, yields are also clearly relevant to allocation. The chart below shows his two types of yields for hybrid mREIT preferred subsectors. The familiar Strip Yield and Long-Term Reset Yield, i.e. the strip yield at the expected end-of-life value of his LIBOR over the next 10 years, about 4%. Stripped Yield is the current yield of these stocks, and LT Reset Yield is the yield that will be earned over the long term unless redeemed. LT No Reset Yield stocks have a fixed interest rate and continue to pay the yield forfeited unless redeemed.

systematic income

systematic income

Highlight the following priorities in subsectors:

Rhythm Capital (former NRZ) (RITM) focuses on serviced properties, non-agency originations, and single-family residential real estate. Book value through the second quarter has held up very well with an overweight in MSRs benefiting from higher interest rates. Unlike nearly all other mREITs, its book value was up 9% year-over-year as of Q2. This maintains strong equity coverage of 5.4x.

The RITM Preferred Stock consists of four shares as shown below. All are now fixed rate, but all will switch to floating rate coupons. Three are based on LIBOR and one is based on the 5-year CMT, or 5-year government bond yield.

Systematic Income Prioritization Tools

Systematic Income Prioritization Tools

Here’s how we expect the yields on these stocks to change going forward. In suites, (RITM.PB) and the (RITM PD). RITM.PD offers portfolio diversification due to its unusual treasury bond yield link, but it takes time to switch. On the other hand, RITM.PB he will switch to floating rate within two years.

Systematic Income Prioritization Tools

Systematic Income Prioritization Tools

Also, MFA Financial (MFA) priority. The company primarily focuses on whole loans such as non-QM and non-qualifying mortgages. MFA primarily raises fixed rate funding, the majority of which is non-marked to market. It has relatively low recourse leverage of 1.8x and Q3 equity/preferred coverage of 4.5x.

The two MFA precedences are:

Systematic Income Prioritization Tools

Systematic Income Prioritization Tools

Their yield profile looks like this: currently holding (MFA.PB) is included in our high income portfolio due to its potential (albeit low probability) redemption and highest yield. However, if short-term interest rates remain high, MFA.PC will look increasingly attractive over time.

Systematic Income Prioritization Tools

Systematic Income Prioritization Tools

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