mtge

Summary

• Investors holding interest rate-sensitive issues have become more nervous as they anticipate, rightly or wrongly, that the Fed may step back from the Zero Interest Rate Policy (ZIRP).
• Income investors seeking a fair return on savings are hard-pressed to find safe places to find decent income as most investments offer little income, are unsafe or both.
• While most pair trades are created to create capital gains, this is a pair trade, targeted at income investors, to identify a way to generate income while taming the risk.
• A long MTGE, paired with a short TLT position (at half the MTGE dollar value), delivers a hedge against future interest rate hikes while providing an outstanding 20% cash return.

Introduction: Income investors have just "celebrated" six and one-half years of the Federal Reserve Bank’s "Zero Interest Rate Policy" (ZIRP). This policy has rendered "traditional safe" investments, where savers could get a decent return while ensuring no capital impairment, useless in their search for income. CDs, savings accounts, and money market funds are yielding zero, leaving savers parched for income from investments appropriate for "traditional savers."

Worse, other types of long-trusted tools for "traditional savers" and retirees have been turned into speculative trading vehicles with this policy. Long the trusted companion of retirees, 10-30-year Treasury bonds are also yielding meager returns of less than 3.5% while posing a serious threat to the capital invested once rates begin to move to higher levels, simultaneously driving down investment values of these nominally "safe" securities.

Municipal bonds offer no safer alternative. Not only do they pose the same interest rate risks for a given maturity length, but the balance sheets and funding capability of many jurisdictions (think Puerto Rico, Illinois, Chicago and the treatment of unsecured municipal bond holders of Detroit debt) do not provide the financial security that has funded secure retirements for past generations of retirees.

This has forced "traditional savers" to move away from the decades-old toolbox of "traditionally safe" investments.

Why I’m Buying MTGE…:

One instrument that continues to provide a very high-income level is the mREITs. Many have expressed concern about the risk of owning such "speculative, unsafe" securities. For example, when I last checked, a broadly-read Seeking Alpha author, Brad Thomas, cannot bring himself to buy mREITs and prefers the safer, "high-quality" REITs that have reliable, steady income (admittedly a very attractive attribute). It is obvious that the market in general agrees with Brad, given the market valuations of the mREITs in general, and MTGE specifically.

While this article concerns a pairs trade, I actually own a very significant position in American Capital Mortgage Investment Corp. (NASDAQ:MTGE) "naked," beginning to build the position last March. Even on its own, MTGE looks to me much more solid than its low market price would suggest; of course, this makes it also a solid core for a pairs trade. Be that as it may, let’s consider MTGE as a "standalone" investment prior to discussing the "paired trade."

One way to do this is to compare MTGE to an investment recently heralded as "one to hold for 10 years" by that same Brad Thomas (full disclosure: I read every one of Brad’s articles that I can find and believe his research high-quality and detailed; however, we just seem to have a different investing philosophy):

Comparing Key Metrics: MTGE vs. STAG

Security	Yield	Price/Book Value
MTGE	11.8%	0.77
STAG	6.5%	1.92

As one can see, MTGE provides a yield 80% higher than STAG while selling at a 23% discount to book value. STAG has a 45% lower yield and sells at nearly twice the value of the underlying assets of the company. It seems that everyone perceives that MTGE is very risky and STAG is very safe. This is reflected in the "comfort premium" pricing at which STAG is selling, for which the market appears to be prepared to pay. I am not, preferring those securities that have already had the stuffing knocked out of it, leaving little remaining risk.

Indeed, MTGE had the "stuffing knocked out of it" during the recent "taper tantrum" in the first half of 2013. During the period from April 22 to July 1, 2013, MTGE dropped from $25.86 to $16.42 or a decline of 36%. At the same time, TLT (a surrogate for long-term rates, as we will discuss) dropped from $123.39 to $106.26 or a decline of 14%. That is, MTGE dropped by a factor of 2.5 times faster than the benchmark (NYSEARCA:TLT) for long-term rates. As of June 11, 2015, MTGE now stands 5% above the level reached at the depths of the taper tantrum, so there is not much recovery in the price of the stock from the 2013 "taper tantrum" low point.

However, it is now a much less risky investment than it was at that time. At the end of 2012, the ratio of total liabilities to net tangible assets was 7.3 (total liabilities = $6,770,578 and net tangible assets = $925,562); in sharp contrast, that same ratio stands at 4.9 (total liabilities of $5,745,206 and net tangible assets = $1,180,705) at the end of Q1’15. Clearly, the managers have also heard that the Fed may be raising interest rates and have acted decisively to prepare for that eventuality.

Evidence of that preparedness can be seen in the period January 26-June 8, 2015, another period of concern about interest rates. During that period, the TLT (benchmark) fell from $138.28 to $115.52 or 16.5%, while MTGE fell from $18.64 to $17.23 or 7.5%. During the more recent decline, MTGE fell at only half of the rate of TLT, as opposed to falling at two and one-half times the rate of the interest rate benchmark in the earlier decline. This suggests that the stock is more prepared for the upcoming interest rate shocks. {Parenthetically, the "high-quality, more stable" STAG fell in that same latter period from $26.20 to $21.21 or 19%, perhaps suggesting that it may not the "fortress of value" that it is purported to be.}

Another potential criticism of the mREITs is that they may be a "sucker yield" (borrowing Brad Thomas’ term), with a decline in dividend yield in the offing. American Capital has managed expectations and existing reality by prudently reducing the yield in line with the income generated by the lower-risk balance sheet. The dividend has already been cut from $0.90/share in Q1’13 down to $0.50/share to reflect the lower earnings. Even at the reduced dividend, the yield is 11.8%. It could be cut by nearly half again and still yield nearly what STAG is providing; alternatively, one could have a portfolio of 50% cash and 50% MTGE, nearly equaling the STAG dividend with only half of the capital at risk. Perhaps speculating on future growth in an uncertain future, STAG (as the company) may or may not do well; on a value basis (and I believe on a return basis on the investment), MTGE is the hands-down winner as it is delivering twice the income (almost) and starting at half the valuation.

So I am buying MTGE, unhedged, as it appears to be an excellent value:

–selling at a 23% discount to net tangible assets,

–providing an 11.8% yield (with a payout less than 100%),

–having de-risked the security by significant de-levering and

–realigning their payout to conform to the "lower earnings but much lower risk" debt to equity profile.

As such, it is a solid investment on its own.

However…

Why I "Am Selling" TLT to Hedge MTGE:

… as Jon Snow had said in recent episodes of "Game of Thrones," "Winter is Coming." Higher interest rates are being signaled as on their way at some time in the intermediate future and we as investors need to face up to that eventuality. Therefore, there is a case to be made for hedging the MTGE position to preserve capital (and probably most other investments as well). That MTGE can be argued to be a good stand-alone investment makes it a good core investment for a hedged, "pair trade" construction as well.

In addition to hedging to avoid losses in portfolio value, there is also an "income enhancement" play that one can secure by pairing a purchase of MTGE with a short on iShares 20+ Treasury Bond that I find attractive as an "income guy" (generating value predominantly through securing income as opposed to focusing exclusively on capital gains).

Consider per-share data for MTGE and TLT:

Data on MTGE and TLT

Security	Price/Share (06/11/15)	Dividend	Comment on Dividend
MTGE	$17.23	$2.00	Expected going forward
TLT	$117.95	$3.306	Last 12 Months

From current pricing, it requires 6.85 shares of MTGE to equal the dollar value of TLT. That is,

6.85 * 17.23 = $118.03, nearly equal to the value of TLT ($117.95).

Secondly, as we saw in the discussion above, the recent period of concern about interest rates saw TLT decline twice as fast as MTGE. If that relationship would come close to holding again, given the de-levered state of MTGE at a price only 5% above the "taper tantrum" level, one can hedge MTGE with TLT at half of the MTGE value. That is,

1 share of TLT at $117.95 to hedge

2 * $117.95 = $235.9 worth of MTGE or 13.7 shares

The combination of 1 share of TLT should offset positive or negative moves of 13.7 shares of MTGE to yield the following "pair trade":

MTGE, Hedged with TLT

Security	Price/Share	Shares	Value
TLT	$117.95	– 1	-$117.95
MTGE	$17.23	13.7	+$236.05
Total – Net			+$118.10

This hedge should minimize losses (or gains). However, it has an even more profound impact on the income per net assets. MTGE has a very high income and the TLT has a very low income, as we pointed out at the top of the article, making TLT cheap financing as a "short." Of course, shorting requires the short seller to replace the income due to the owner of the borrowed stock; in other words, the short seller would need to be providing the $3.306/share dividend due the security owner from whom it is borrowed, setting up the following net income scenario:

Net Income Generated from Long MTGE-Short TLT "Pair Trade"

Security	Share(s)	Dividend/Share	Income
MTGE	+13.7	$2.00	+$27.400
TLT	– 1.0	$3.306	-$3.306
Total – Net	N/A	N/A	+$24.094

Calculating "dividend yield" on the "pair trade" hedge, one generates:

Net Dividend from the pair = $24.09 divided by the

Net Asset Value of the "Paired Trade" = $118.10/share yields

the "Pair Trade" Dividend Yield

= $24.09/$118.1 = 0.204 or a 20.4% yield on the "hedged" pair.

As such, pairing a high-yielding long with a very low-yielding short can generate a very high-yielding hedged construction by virtue of the "cheap" money "borrowed" through the short position. ZIRP can work for you, in this specific situation, to really amp up the income and yield.

Summary:

Savers have struggled to find yield since the financial crisis of 2008. Now, the "other shoe is ready to drop" with the potential for the Federal Reserve to raise interest rates threatening the very high valuations of most assets, resulting from using historically low discounting rates, to which savers have resorted in a chase for yield.

One security that seems to offer a better balance of value, security and return is MTGE, even if the market does not perceive it as such. This security offers good valuation (23% discount to net tangible assets), high yield (11.8%), a lower risk balance sheet through de-levering the fund by a third in three years relative to assets and re-aligning the payout to the lower earnings profile (through prudently reducing risk). Standing about 5% above the post "taper tantrum" low point, MTGE as a standalone security looks to me to be an excellent value, even if the market doesn’t think so.

MTGE also provides a solid core for a "pairs" trade to hedge upcoming interest rate increases. Pairing long MTGE with a short position in TLT at half the dollar value of the long MTGE position provides a construction that should be relatively robust to the upcoming interest rate increases. It enables the "pairs holder" to capture the very high income of the long MTGE position while mooting the risk that one is supposedly being paid to take. Finally, due to historically low interest rates, TLT as a short provides a low cost funding in the paired trade, enabling the "paired trade" to generate a 20% cash return on the net asset value of the "pair." While not generating a large (or any) capital gain (given the "pairs trade" design to avoid "pair" value movement in either direction), a 20% cash return, net of interest carry on the short TLT position, provides an outstanding risk-reward offered by few other trades.

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