Last night’s question from Dan led to a fairly technical and complicated answer about the current state of the mREIT sector.
Again without giving specific investment advice (since I have no idea what your specific circumstances are), I thought I’d put into words a little technical primer on picking up bargains when the market gods are slamming these stocks.
I’ll try to describe how I pick them, leaving how my emotional and financial state affects my order of choice for another time. Just be aware that your own ability to sleep at night, or need for cash, can radically change your order of preference among these stocks. Right now, I’d say the fear factor has driven a lot of small investors to sell, simply because they don’t like the sickening feeling of seeing red pixels on their screen full of stock prices.
First and foremost, I look at the management team and their track record, especially if that track record includes dramatic changes in the investing environment, since surviving challenges can be even more important than making money when the sun shines.
I do make an exception to the management team as primary filter when the stocks trade at a severe discount to the liquidation value of the portfolio. After all, when talking about amREITs (Agency MBS REITs), the credit issue is off the table, so only risk to capital value is an open question.
In the case, as now, that the group is trading at or below liquidation (book) value, I look at further risk to that value to see if the discount is sufficient to cover all reasonable risks. In that case, it’s the management teams that have the lowest “effective duration” or “duration gap” which present the best value if the stocks are trading at similar discount.
For those whose eyes glaze over at the word “duration” I have several definitions that may help. First the formal definition, from Investopedia:
Definition of ‘Macaulay Duration’
The weighted average term to maturity of the cash flows from a bond. The weight of each cash flow is determined by dividing the present value of the cash flow by the price, and is a measure of bond price volatility with respect to interest rates.
The most common way to describe its practical use is to say that duration measures the sensitivity of a bond or portfolio to changes in interest rates. When I had to explain duration, I found a couple of ways to tell them how to use it without the math:
Think of it as the holding period for the bond until it reprices, or alternatively, as a holding period for which you will be indifferent whether rates go up or down.
Those who remember high school physics can see how it works (the interest rate sensitivity measure), by thinking of the price/yield curve as a graph, or by looking at that curve printed out from the research group’s analytics. The slope of the curve at any given yield is the duration. It’s like the velocity if you looked at the graph of position vs. time in physics.
(Incidentally, the second derivative of that curve is the convexity of the bond — pretty much the same as acceleration in the high school physics analogy. We often hear or read of “negative convexity” for mortgage bonds, though the cases of actual negative convexity are very rare. More to the point, mortgage bonds are less positively convex than fixed maturity Treasuries and corporates.)
In general, bonds have positive duration, and financing and/or hedges have negative duration. A portfolio of MBS, together with its financing and its hedges, has a duration as well, computed by adding together the durations of the separate components.
Now here’s where it gets interesting.
Since home buyers tend to refinance when rates go down and hold on for better rates when mortgage rates go up, the stream of payments can shorten or extend. Naturally, the duration goes up and down with that extension or contraction. An MBS portfolio manager must therefore constantly manage the hedge and the financing to adjust for changing outlooks, outlooks that are reflected in the price of the bonds themselves.
So that’s why most of us in the business settle for a somewhat “fuzzy” number we call “effective” duration, and why we look at options and swaps and options on swaps to build our portfolios.
Returning to the current market, historically Capstead (symbol CMO) has tried the hardest to hold short duration bonds (floating rate MBS that reset, or reprice, very frequently). With the shortest duration of their portfolio before hedging, they can match up the expected principal balances with commitments for financing, and reduce their effective duration to near zero. Anworth (ANH) holds adjustable rate MBS as well, but they usually buy them during the early fixed-rate period as “hybrid” Agency MBS. Then they get financing and swap commitments to cover the first few years when the MBS are paying fixed interest rates. Other than principal paydown risk that puts them out of balance ANH also plays with effective duration as close to zero as they can keep it.
TWO and CYS also tend to keep their effective durations short, but they do so with more inherent risk because the long side of their portfolios have more fixed rate bonds.
The management teams at NLY and AGNC have historically taken quite a bit more interest rate risk, sometimes holding even effective durations as long as three years. Given the past few years of zero short term rates, this has paid off with huge earnings, which enabled them to raise more capital repeatedly, selling new stock at decent premiums to book value.
In a later post, I’ll describe the “virtuous” Ponzi scheme — the mathematical fact that raising new capital at a premium to current book value actually increases the ROE for current shareholders. Imagine that!