Picking Up Bargains

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.

Here’s the formula itself.

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!
hh

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16 Responses to Picking Up Bargains

  1. George Maniere says:

    I am a fellow VF member and this is hands down, the best blog on the web. Very interesting and timely post today.

  2. I’ve lost thousands on the bargains I’ve picked up today. Hope things are well. Give me a call if you want to talk or I might give you one

  3. kurtwalter at VF says:

    A number of Youtube videos on duration have helped me understand the concept – such as the graphical presentation at https://www.youtube.com/watch?v=9HFLGNaEWl8 So basically we are talking about interest rate (price) sensitivity of bonds. Where we can we find information on this for each AMREIT so we can find bargains? Second, isn’t this trend offset at least partially by CPRs – which are influenced by the size of the mortgages, as in the case of AGNC preferring small mortgages that are not likely to be prepaid because of the relative cost of doing so.

    • hhill51 says:

      That information is not available for each amREIT. Some will say what it is during conference calls, but it is not required disclosure. Also, as you are suggesting, it’s really all about the CPR, and more importantly, what happens as rates change and the CPR changes. Today, with these intensely low rates, the huge risk is extension. Back in the early 80’s people who had older low rate mortgages (eg 6% when rates were at 11% or 12%), they started selling their houses while simultaneously doing private mortgages with the buyers to keep the existing mortgage in place. I fully expect arrangements like that if we see 8% rates a few years from now, and people want to sell houses for which they have sub-4% fixed rate mortgages today. That could turn the average life from the 5 to 7 years the amREITs are assuming right now to 15 or 20 years! Talk about duration extension! That’s why adjustables don’t lose value the same way fixed rate mortgages do… they reset. All bonds reprice to a higher yield when rates go up, but ARMs catch up over time with the higher rates and once again become par bonds. That’s why I say the holders of fixed MBS have more capital risk, even if they have zero effective duration today. Lots of moving parts in these things, which is why we used to use all the computers in the whole firm as a giant parallel processor to run our nightly risk models.

  4. kurtwalter at VF says:

    Will be a few years at least before we see any uptick in interest rates, and by that time it may be necessart to shift investment strategies. I know you’re not an investment advisor, but can you list your favourite mortgage REITs?

    • hhill51 says:

      Below 60% of book value, I just close my eyes and buy, as long as the yield curve is sloping upward. At 60% to 70% of book, the lower the underlying portfolio duration, the better (ie without hedges). At 70% to 85% of book, a hedged duration near zero works, but I would like to look at the hedges. Some managers hedge by locking in longer dated swaps to ensure positive carry, while others use shorter hedges like Eurodollar futures, which result in double or triple counting because the Eurodollar contracts end every three months, while the swaps are essentially similar to a series of futures contracts. (IF the managers tell you their “effective duration” they will take this into account and will not be double counting — but if they just tell you what percentage hedged they are using face amounts, the effective duration can still be quite long.)

      I’ve been disappointed so many times by the conservative (lock in spread via swaps) team at Anworth as they failed to garner increased book value these past two years, yet their stock is so much cheaper that I find myself drawn yet again to buy them around $6 a share, and at $5 I would back up the truck and load it. As I said the other day, NLY is busy turning itself into a sector ETF, and the transfer pricing may end up being a bit high as they buy their own affiliated non-Agency REITs rather than executing open market purchases, so it would have to fall another couple of points to get me excited. At single digits, I buy CYS and TWO and CMO with both hands, and the same with MITT (I know, non-Agency) in the teens. Too much is going on with IVR in that sector, as they maneuver to sell the servicing operation they picked up during the great purge of mortgage banking. AGNC hasn’t existed through a rate rising or inverted yield curve cycle, but they’re pretty sharp, so I would be interested at a discount more than 12% to book, and I’d probably use technical chart trading to pick an entry point.

      Hope this helps.

      • kurtwalter at VF says:

        Thanks – very helpful.

      • hhill51 says:

        By the way, since I’ve been mostly out of the mREIT group for a few months (see my ARNA play-by-play), I had to go back and check book values. TWO has held up a little better (good management team at Pine River), so it should really be below $9 a share to make it an equivalent bargain to CYS or CMO under $10.

  5. kurtwalter at VF says:

    Would you mind if I repost your preferences on ValueForum?

  6. old gringo says:

    Thanks most enlightening.

  7. Kein Egan says:

    Always enjoy reading your blog. Thanks and have a Happy Thanksgiving.

  8. Tom Drake says:

    Hi Howard,
    Appreciate the updates on mREITs. I have been down because of death in family but managed to exit all mR’s except preferreds and TWO, just on a “market feel analysis” basis.
    In southern Mexico this winter but communications are good. Glad your hurricane damage was limited. This is heavy hurricane history territory…
    Tom D

    • hhill51 says:

      Hey, Tom….

      Sorry to hear about the sad event. I’m still trying to figure out what to do with the detritus from the hurricane. I shouldn’t burn it in my fireplace because of the pitch in evergreens, but I’m tempted to install an outdoor furnace, given the fact that I could heat my house for winter with the amount of wood that’s fallen. That would almost pay for installation of a 200,000 BTU outdoor furnace the first season.

      You should check out the follow-up post to this one, called “virtuous Ponzi”… It was written on a day when most of the mREITs could increase per-share earnings by buying back stock in the market, so I wasn’t surprised when several of them did just that.

      For some retail investors, it was a great opportunity to reload.

      Take care,
      Howard

  9. John says:

    What do you think of NYMT?

    • hhill51 says:

      I have personal history with that group, including having presented (a few years ago) the current strategy of buying FHA project loans in lieu of conventional Agency MBS. It’s a good strategy, though it requires higher leverage to produce double-digit returns. That said, there are subtleties in the FHA project loan market that take years or even decades to learn. It’s not clear they have that expertise on board. I don’t follow it as closely as I used to. Buying at 85% of book value is a safe bet.

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