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UPDATE: Profiting From A Steepening Yield Curve

In June we wrote an RIA Pro article entitled Profiting From A Steepening Yield Curve, in which we discussed the opportunity to profit from a steepening yield curve with specific investments in mortgage REITs. We backed up our words by purchasing AGNC, NLY, and REM for RIA Advisor clients. The same trades were shared with RIA Pro subscribers and can be viewed in the RIA Pro Portfolios under the Portfolio tab.

We knew when we published the article and placed the trades that the short term risk to our investment thesis was, and still is, a further flattening and even an inversion of the yield curve. That is precisely what happened. In mid to late August the curve inverted by four basis points but has since widened back out.

The graph below compares the 2s/10s yield curve (blue) with AGNC (orange) and NLY (green). Beneath the graph is two smaller graphs showing the rolling 20-day correlation between AGNC and NLY versus the yield curve.

Since writing the article and purchasing the shares, the securities have fallen by about 5%, although much of the price loss is offset by double digit dividends (AGNC 13.20%, NLY 10.73%, and REM 9.06%). While we are not happy with even a small loss, we are emboldened by the strong correlation between the share prices and the yield curve. The trade is largely a yield curve bet, so it is comforting to see the securities tracking the yield curve so closely.

We still think the yield curve will steepen significantly. In our opinion, this will likely occur as slowing growth will prompt the Fed to be more aggressive than their current posture. We also think that there is a high probability that when the Fed decides to become more aggressive they will reduce rates at a faster clip than the market thinks. As we discussed in Investors Are Grossly Underestimating the Fed, when the Fed is actively raising or reducing rates, the market underestimates that path.

To wit:  If the Fed initiates rate cuts and if the data in the graphs prove prescient, then current estimates for a Fed Funds rate of 1.50% to 1.75% in the spring of 2020 may be well above what we ultimately see. Taking it a step further, it is not farfetched to think that that Fed Funds rate could be back at the zero-bound, or even negative, at some point sooner than anyone can fathom today.

Heading into the financial crisis, it took the Fed 15 months to go from a 5.25% Fed funds rate to zero. Given their sensitivities today, how much faster might they respond to an economic slowdown or financial market dislocation from the current level of 2.25%?”

Bolstering our view for a steeper yield curve is that the Fed, first and foremost, is concerned with the financial health of its member banks. The Fed will fight an inverted yield curve because it hurts banks profit margins and therefore reduces their ability to lend money. Because of this and regardless of the economic climate, the Fed will use words and monetary policy actions to promote a steeper yield curve.

We are very comfortable with the premise behind our trades, and in fact in mid-August we doubled our position in AGNC. We will also likely add to NLY soon.

For more on this investment thesis, please watch the following Real Vision interview Steepening Yield Curve Could Yield Generational Opportunities.

Steepening Yield Curve Could Yield Generational Opportunities : Michael Lebowitz on Real Vision

On July 1st, Michael Lebowitz was interviewed by Real Vision TV. In the interview he discussed our thoughts on the yield curve, corporate bonds, recession odds, the Federal Reserve, and much more. In particular, Michael pitched our recent portfolio transactions NLY and AGNC, which were both discussed in the following RIA PRO article: Profiting From a Steepening Yield Curve.

Real Vision was kind enough to allow us to share their exclusive video with RIA Pro clients. We hope you enjoy it.

To watch the Video please click HERE

Profiting From A Steepening Yield Curve

What is the yield curve and what does it mean for the economy and the markets?

Over the last few months, the financial media has obsessed on those questions. Given the yield curve’s importance, especially considering the large amount of debt being carried by individuals, corporations, and the government, we do not blame them. In fact, we have given our two cents quite a few times on what a flattening and inversion of various yield curves may be signaling. Taking our analysis a step further, we now look at investment ideas designed to take advantage of expected changes in the yield curve.

An inversion of the 2yr/10yr Treasury yield curve, where yields on 10-year Treasury notes are lower than those of 2-year Notes, has accurately predicted the last five recessions. This makes yield curve signaling significant, especially now. It is important to note that in the five prior instances of yield curve inversions, the recession actually started when, or shortly after, the yield curve started to steepen to a more normal positive slope following the inversion. In our opinion, the steepening, and not the flattening or inversion of the curve, is the recession indicator.  

As discussed in Yesterday’s Perfect Recession Warning May Be Failing You, we believe the 2yr/10yr curve may not invert before the next recession. It may have already troughed at a mere 0.11 basis points on December 19, 2018. If we are correct, the only recession warning investors will get could be the aforementioned curve steepening. Another widely followed curve spread, the yield difference between 3-month Treasury bills and 10-year Treasury notes, recently inverted and troughed at -25 basis points, which makes the likelihood of a near-term recession significant.

The remainder of this article focuses on REITs (real-estate investment trusts). Within this sector lies an opportunity that should benefit if the yield curve steepens, which we noted has occurred after an initial curve inversion and just before the onset of the last five recessions.  

What is an Agency Mortgage REIT?

REITs are companies that own income-producing real estate and/or the debt backing real estate. REITs tend to pay higher than normal dividends as they are legally required to pay out at least 90% of their taxable profits to shareholders annually. Therefore, ownership of REIT common equity requires that investors analyze the underlying assets and liabilities of the REIT to assess the potential flow of income, and thus dividends, in the future.  

The most popular types of REITs are called equity REITs. These REITs own equity in apartments and office buildings, shopping centers, hotels and a host of other property types. There is a smaller class of REITs, known as mortgage REITs (mREITs), which own the debt (mortgages) on real-estate properties. Within this sector is a subset known as Agency mREITs (AmREITs) that predominately own securitized residential mortgages guaranteed against default by Fannie Mae, Freddie Mac, Ginnie Mae and ultimately the U.S. government.

From an investor’s point of view, a key distinguishing characteristic between equity REITs and mREITs is their risk profiles.  The shareholders of equity REITs are chiefly concerned with vacancy rates, rental rates, and property values.  Most mREIT shareholders, on the other hand, worry about credit risk and interest rate risk. Interest risk is the yield spread between borrowing rates and the return on assets. AmREITS that solely own agency guaranteed mortgages assume no credit risk as timely payment of principal and interest is advanced by the security issuer (again either Fannie Mae, Freddie Mac, or Ginnie Mae, all of whom are essentially government guaranteed). Therefore, returns on AmREITs are heavily influenced by interest rate risk. Almost all REITs employ leverage, which enhances returns but adds another layer of risk.

Agency mREITs

Earnings for AmREITs are primarily the product of two sources; the amount of net income (yield on mortgages they hold less the cost of debt and hedging) and the amount of leverage.

A typical AmREIT is funded with equity financing and debt. The capital is used to purchase government-guaranteed mortgages. Debt funding allows them to leverage equity. For example, if a REIT bought $5 of assets with $1 of equity capital and $4 of debt, they would be considered 5x leveraged (5/1). Leverage is one way REITs enhance returns.

The second common way they enhance returns is to run a duration gap. A duration gap means the REIT is borrowing in shorter maturities and investing in long maturities. A 2-year duration gap implies the REIT has an average duration of their liabilities that is two years less than the duration of their assets. To better manage the duration gap and the associated risks, REIT portfolio managers hedge their portfolios. 

The Fed’s Next Move and AmREITs

With that bit of knowledge, now consider the Fed’s quickly changing policy stance, how the yield curve might perform going forward, and the potential impact on REITs.

Recent speeches from various Fed members including Chairman Powell and Vice Chairman Clarida are leading us and most market participants to believe the Fed could lower rates as early as the July 31st FOMC meeting. Most often, yield curves steepen when, or shortly before, the Fed starts lowering rates. While still too early to declare that the yield curve has troughed, it has risen meaningfully from recent lows and is now the steepest it has been since November of 2018.  

If we are correct that the Fed reduces the Fed Funds rate and the yield curve steepens, then AmREITs should benefit as their borrowing costs fall more than the yields of their assets. Further, if convinced of a steepening event, portfolio managers might reduce their hedging activity to further boost income. The book value of AmREITs have a strong positive correlation with the yield curve, and as a result, the book value per share of AmREITs should increase as the curve steepens.

The following two graphs compare the shape of the 2yr/10yr yield curve versus the book value per share for the two largest AmREITs, Annaly Capital Management (NLY) and AGNC Investment Corporation (AGNC). The third and fourth graphs below show the same data in scatter plots to appreciate the correlation better. The current level of book value per share and yield curve is represented by the orange blocks in each scatter plot. Statistically speaking, a one percent steepening of the yield curve should increase the book value per share by approximately $2 for both stocks. Given both stocks have dividend yields in the low double-digits, any book value appreciation that results in price appreciation would make a good return, great.

Data Courtesy Bloomberg

While a steepening yield curve will likely create more spread income and thus a higher book value for these REITs, we must also consider the role of leverage and the premium or discount to book value that investors are currently paying.  

  • NLY is employing 8.2x leverage, which is slightly higher than their average of 7.6x since 2010, but less than their 20+ year average of 9.94.
  • AGNC uses more leverage at 10.2x, which is higher than their average of 8.8x since 2010. The REIT was formed in late 2008, therefore we do not have as much data as NLY. 
  • NLY trades at a discounted price to book value of .94, slightly below their historical average
  • AGNC also trades at a discounted level of .92 and below their historical average.

The risks of buying AGNC or NLY are numerous.

  • We may be wrong about the timing of rate cuts and the curve may continue to invert, which would decrease book value. In such a case, we may see the book value decline, and potentially even more damaging, the discount to book value decreases further, harming shareholders.
  • Even if we are right and the yield curve steepens and the REITs asset/liability spreads widen, we run the risk that investors are nervous about real-estate going into recession and REITs trade to deeper discounts to book value and effectively offset any price appreciation due to the increase in book value.
  • Leverage is easy to maintain when markets are liquid; however, as we saw a decade ago, REITs were forced to sell assets and reduce leverage which can also negatively affect earnings and dividends. It is worth noting that NLY had an average of 12.90x leverage in 2007, which is significantly larger than their current 8.20x.


Despite double-digit dividend yields and the cushion such high dividends provide, buying NLY or AGNC is not a guaranteed home run. The two REITs introduce numerous risks as mentioned.  That said, these firms and other smaller AmREITs, offer investors a way to take advantage of a steepening yield curve while avoiding an earnings slowdown that may hamper many stocks in an economic downturn.

While NLY and AGNC are in the same industry, they use different portfolio tactics to express their views. As such, if you are interested in the sector, we recommend diversifying among these two companies and others to help reduce idiosyncratic portfolio risks. We also recommend investors assess the IShares Mortgage Real ETF (REM). Its two largest holdings, accounting for over 25% of the ETF, are NLY and AGNC.  It is worth noting however, this ETF introduces risks not found in the AmREITs. The ETF holds the shares of mortgage REITs that contain non-guaranteed mortgages as well as mortgages on commercial properties.

Monthly Fixed Income Review – December 2018

The fourth quarter of 2018 was a bad year for lower rated, riskier fixed income products.

In review of December’s fixed-income performance as well as 2018 in general, there are a few key themes that are prevalent.

  1. Interest rates moved higher throughout the first three quarters of the year and then abruptly reversed course and reclaimed nearly 75% of the selloff from the first nine months (5, 7, 10 and 30-year U.S. Treasury bonds).
  2. After outperforming all other primary fixed-income sectors for the first nine months, high yield bonds collapsed in the final three months finishing the year with negative total returns.
  3. Investment grade corporate bonds and emerging market bonds were the worst performing sectors throughout the year losing roughly 2.50%.
  4. Without regard for the direction of interest rates, the yield curve continued to flatten as Fed policy and more recently economic concerns caused the short end (2-year Treasuries) to underperform and the long end (10-year and 30-year bonds) to outperform.
  5. December proved exceptionally strong for safe haven securities like Treasuries, municipal securities and mortgages helping turn those categories positive for the year.

There were numerous times throughout the year when our recommendation to take a conservative tack by moving up in credit and avoiding the more expensive and riskier fixed income categories seemed foolish. In hindsight, the description foolish should be replaced with smart.

Investors can draw a bright line at September 30, 2018 as a point of demarcation. Prior to that date, high yield and other risky sectors like leveraged loans, could do no wrong while every other fixed income asset class languished as interest rates rose. With the economy humming along, employment and hiring robust and inflation concerns burgeoning, the Fed was methodically hiking interest rates. The adjustable rate of interest on leveraged loans made them attractive in a rising rate environment and the higher coupons and shrinking supply of junk bonds (high yield securities) similarly made them appetizing to investors. The last thing investors were worried about in a strengthening economy was credit related losses.

Complacency peaked at the end of September, with fresh record highs in the stock market and favorable returns from its closest proxy, high yield debt. A variety of issues have since emerged as global growth is slowing rapidly and the benefits of domestic fiscal policy move past their point of peak contribution. Needless to say, optimism is waning. The chart below shows how high-yield debt languished in the final three months while safer sectors performed admirably.

As we have expressed throughout the year, there is a lot to worry about in the world and the United States is not immune to those concerns. Concurrently, U.S. markets have assigned expensive prices to the riskiest of assets. For all of 2018, we have urged readers to adjust their investment posture increasingly toward protecting capital. Although now the second longest in recent history, the current expansion has been the weakest on record as it was mostly promoted by artificial stimulus and incremental increases in all forms of debt. Temporarily supportive of growth, rising debt loads create their own headwind and eventually lead to instability. That is in fact what we appear to be witnessing.

The optimists will say that recent underperformance sets the stage for a terrific buying opportunity and that may well be, but value investors are more discerning. The hiccup in performance in the fourth quarter is likely a harbinger of more difficulties to come as China, Europe, Australia and Japan all demonstrate weakening trends in growth and troubling strains from imprudent debt accumulation. It is important to note that approximately 40% of U.S. corporate earnings come from foreign sales.

The United States may soon face similar issues given the sensitivity of our economy to high and rising debt. To the extent that the Fed has properly chosen to wean our economic decision-making off of crisis-era policies, albeit belatedly, those assets that have been the biggest beneficiaries of such policies should also brace to bear the burden of their removal. What we are beginning to see is the lagged effects of higher interest rates and less artificial liquidity as a result – the tightening of financial conditions.

The “tell” has been the Treasury yield curve. Using the spread between 2-year and 10-year Treasury yields, 2018 provided many insights. The 2s-10s curve spread declined throughout most of the year which encompassed both rising rates and falling rates. The price of money, the basis upon which all other assets derive their projections of value, implied that there was a growing concern for rate hikes and inflation (rates up) through the third quarter and then a growing concern for a recession (rates down) thereafter.

Higher risk investment credit is likely to languish for quite some time or at least until the trajectory of the economy becomes clearer. As revealed by high yield bond performance and the direction of interest rates, the trends of 2018 are clear. Our prior guidance of moving up in to higher quality credit and into safer categories of the fixed income markets still holds.

All data courtesy Barclays

Monthly Fixed Income Review – November 2018

The price depreciation of risky assets in the financial markets continued through most of November but took a breather late in the month. The rebound in the final week provided for month-end to month-end optics that were otherwise better than what one might expect had they been watching markets transpire day-to-day.

Performance across the fixed-income sector was reflective of the recent challenges that extended into November. The list of issues included the sell-off of General Electric stock and bonds, Brexit uncertainty and the devastation and financial uncertainty associated with the California wildfires. The market reaction to these events has been justifiably imposing and leaves investors to consider the anxiety-inducing potential for contagion risk.

Money flowed into the safety of Treasuries, mortgages and municipal securities (Munis) and out of corporate bonds and emerging market bonds. As for year-to-date performance, only munis and high-yield corporate bonds are positive at this point, and in both cases, just barely.  All other sectors are negative.

ETFs performed similarly but the Muni bond ETF, unlike the index, is now negative on a year-to-date basis. Somewhat surprisingly and concerning, the emerging market ETF (EMB) is down almost twice the index (-7.24% vs. -3.79%) on a year-to-date basis.

Corporate credit spreads widened meaningfully in November largely offsetting the decline in Treasury yields. Investors appear to be contemplating an imminent slowdown in corporate earnings growth and the associated rating implications. This will be an important story to follow given the large percentage of companies that are BBB, and near junk status. The decline in crude oil prices, down -33% from the early October high, among other languishing commodities raises further concerns about a broader global growth slowdown.

Looking in detail at high yield sector spreads, the best junk rating (BB) widened only modestly (+85 bps) off recent tight levels while the worst rating (CCC) widened substantially (+255 bps).

Considering the drop in the price of crude oil in recent months, an evaluation of the relationship between high yield spreads and oil prices is informative and troubling. As shown in the chart below, crude oil prices below $50 over the past four years are associated with significantly wider high yield spreads.

Finally, there has been a lot of recent discussion about various yield curves beginning to invert. In U.S. Treasuries, the 2y-3y part of the curve is now imperceptibly positive (less than 1 basis point), and the 2y-5y curve is slightly negative. Treasury yields and various curves are highlighted below.

In recent history, an inverted yield curve has implied the eventuality of a recession. Based on the financial media and research from Wall Street, the current yield curve trends are becoming worrisome for investors. While there are good reasons for an economy so dependent on activities associated with borrowing and lending to succumb to an inverted curve, the anxiety being projected is probably more troubling at this stage than the early phase of this event. It is important to watch but should not be a major concern just yet.

Given the volatility in stocks and other risky assets in the early days of December, it remains unclear whether investors should count on the traditional healthy seasonal performance to which they have become accustomed. Uncertainties about the economic and geopolitical outlook loom large, urging a cautious approach and defensive posture in the fixed-income sector. Safer sectors, such as Treasuries, MBS and munis might continue to benefit if recent market turmoil continues.

Data source: Barclays

Monthly Fixed Income Review – October 2018

October 2018 was decidedly a “risk-off” month and posed a challenge for every asset class within the fixed-income market. In terms of total return, U.S. Treasuries performed the best (down -0.48%) while investment grade corporates, high-yield and emerging market bonds all posted losses of over 1%. For emerging markets, it was the worst monthly performance since November 2016 and for high-yield, the worst since January 2016. Year-to-date, however, only the high-yield sector remains positive up +0.96%.

A new addition to the monthly fixed-income review is a composite of spread changes as seen in the table below. The data in this table are option-adjusted spreads (OAS). Positive numbers reflect spread widening or higher yields relative to the benchmark which is what normally occurs in months of poor performance. Negative numbers are spread tightening which is constructive. The OAS is measured in relation to the U.S. Treasury benchmark curve.

As illustrated in the table, most OAS spreads are wider across every time frame but not dramatically so. The fact remains that in a historical context, spreads remain very tight to the benchmark. As a point of comparison, current high-yield spreads are 3.71% (371 basis points) above the benchmark curve. In January 2016, they were 7.33% above the benchmark.

In a rather unusual turn of events, despite the sell-off in equity markets, Treasury yields uncharacteristically rose. Over the course of the past 30 years, when we have seen stress emerge in risky assets like that which occurred in October, U.S. Treasuries experience a flight-to-quality bid and yields fall. One could argue that October was an anomaly, but the same thing happened this past February and March.

This irregular relationship may be due to one of a couple of factors, some of both or another unidentified dynamic. Either (1) the correction in equity markets did not stir investors’ fear of a deeper correction given the strength of the economy or (2) on-going concern about heavy U.S. Treasury supply prevented yields from falling. In any event, it is highly unusual and may represent a troubling change in the contour of the markets. The absolute level of interest rates remains low by historical measures but after nearly 10 years of zero-interest rate policies and little volatility, it is the change in rates that matters most to investors and borrowers. Similar increases in rates in prior periods were destabilizing to the equity markets.

The implications of higher interest rates are beginning to show in housing and auto activity. Neither industry, both vital to economic growth in the recent expansion, is collapsing but both are demonstrating a clear weakening trend. In the modern age of excessive debt, this is how topping markets typically progress.

October unveiled another bout of higher volatility, higher interest rates and falling asset prices. This may be a temporary setback but given the age of the cycle, how tight credit spreads are, and the economy’s dependence on debt, we would not advise throwing caution to the wind.


A Preferred Way to Generate Yield – Part 2 Trade Idea

The following article expands on, A Preferred Way to Generate Yield, by exploring the preferred shares of Government Guaranteed Agency-Backed Mortgage Real Estate Investment Trusts (REIT) and discussing a compelling trade idea within this sector. Neither the common nor the preferred equity classes of this style of REIT are widely followed, which helps explain why the opportunity of relatively high dividends without excessive risk exists.

What is a Mortgage REIT?

Real estate investment trusts, better known as REITs, are companies that own income-producing real estate and/or the debt backing real estate. REITs are legally required to pay out at least 90% of their profits to shareholders. Therefore, ownership of REIT common equity, preferred equity and debt requires that investors analyze the underlying assets and liabilities as well as the hierarchy of credit risks and investor payments within the capital structure.

The most popular types of REITs are called equity REITs (eREIT). They own apartment and office buildings, shopping centers, hotels and a host of other property types. There is a smaller class of REITs, known as mortgage REITs (mREIT), which own the debt (mortgage) on real-estate properties. Within this sector is a subset known as Agency mREITs that predominately own securitized residential mortgages guaranteed against default by Fannie Mae, Freddie Mac, Ginnie Mae and ultimately the U.S. government.

The main distinguishing characteristic between eREITs and mREITs is in their risk profiles.  The shareholders of eREIT securities primarily assume credit risk associated with rising vacancies and declining property values. Most mREITs, on the other hand, take on less credit risk. Instead, their dividends are largely based on interest rate risk or the yield spread between borrowing rates and the return on assets. Agency mREITS that solely own agency guaranteed mortgages take on no credit risk. Mortgage and equity REITs frequently employ leverage which enhances returns but adds another layer of risk.

Mortgage REIT Capital Structures

MREIT’s use debt, common equity, preferred equity and derivatives to fund and hedge their portfolios. Debt is the largest component of their capital structure, often accounting for more than 75% of the financing. Common equity is next in line and preferred equity is typically the smallest. The REITs choice of financing is generally governed by a balance between cost and desired leverage.

When a REIT issues common or preferred equity, leverage declines. Conversely, when debt is employed, leverage rises. The decision to increase or decrease leverage is often a function of balance sheet preferences, hedging strategies, market views and the respective costs of each type of financing. The choice between preferred and common is frequently a function of where the common stock is trading versus its book value as well as the financing costs and liquidity of the two options.

Selecting Agency mREIT Preferred Shares

Agency mREIT (again holding predominately government-guaranteed mortgages) preferred shares currently offer investors a reasonable return with manageable risk. In the current environment there are two primary reasons why we like preferred securities versus their common shares:

  • Discount to Book Value- Currently, several of the Agency mREITs that offer preferred alternatives are trading at price -to- book values below 1.0. While below fair value, we are worried shareholders might get diluted as they are at or near levels where new equity was issued in the past. We prefer to buy the common shares at even deeper discounts (in the .80’s or even .70’s) for this reason. Discriminating on price in this way offers a sound margin of safety where the upside potential is enhanced and risk of new share issuance diminished.
  • Interest Rate Risk- The Fed is raising rates and the yield curve is generally flattening. Profitability of mREITs is largely based on the spread between shorter-term borrowing rates and longer-term mortgage rates. As this differential converges, mREIT profitability declines. Also, as mentioned in our Technical Alert – 30 Year Treasury Bonds, longer-term yields might be reversing a multi-decade pattern of declining yields. While the funding spread is a key performance factor, rising yields introduce complexities not evident in a falling rate environment. Namely, hedging is more difficult and asset prices decline as rates rise. While we still think probabilities favor lower yields, a sustainable break in the long-term trend must be given proper consideration as a risk.

Before selecting a particular REIT issuer and specific preferred shares, we provide a list of all Agency mREIT preferred shares that meet our qualifications.

Data Courtesy Bloomberg

As shown in the Yield -to- Worst column (far right), the lowest expected yields are somewhat similar for all of the issues with five or more years remaining to the next call date.

To help further differentiate these issues, the table below highlights key risk factors of the REITs.

Data Courtesy Bloomberg

The bullet points below describe the four factors in the table:

  • Leverage Multiple– This is the ratio of total assets to common and preferred equity. Higher leverage multiples tend to result in bigger swings in profitability and the potential for a reduction in common and preferred dividends. It is important to note that leverage can change quickly based on the respective portfolio managers view on the markets.
  • Price -to- Book Value (P/B)– This is the ratio of the market capitalization of the common stock to the value of the assets. As the P/B approaches fair value (1.00) the odds increase that common or preferred equity may be issued, putting shareholders at the risk of dilution. The column to the right of P/B provides context for the range of P/B within the last five years.
  • 1 and 3 Year Price Sensitivity– This measures the change in book value as compared to the change in U.S. Treasury yields over selected time periods. This is an indication of hedging practices at each of the firms. The lower the number, the more aggressively they are hedging to protect against changes in yields. This measure, like leverage, can change quickly based on the actions of the firm’s portfolio managers.
  • Preferred as a Percent of Total Equity– This metric offers a gauge of the percentage of preferred shares relative to all equity shares. Preferred shareholders would rather this ratio be small. However, if the number is too low versus competitors, it might mean that preferred shares will be issued soon which would temporarily pressure the price of existing preferred shares.

Trade Idea

Given the current interest rate volatility and the potential for large binary moves in mortgage rates, we think Two Harbors Investment Corporation (TWO) appears to present the least overall risk based on the measures above. In particular, we are focused on their aggressive hedging strategy which has resulted in the lowest interest rate sensitivity over the one and three year time periods. A closer look at performance since June 2016, the point at which interest rates began to rise, also argues in favor of TWO as they have produced superior risk-adjusted total returns.

Data Courtesy Bloomberg

We are largely indifferent between the preferred issues of TWO (A, B and C) shown in the first table. The investor must choose between a preference for a higher coupon and a price above par ($25), and a lower coupon but price below par. On a total return basis, they yield similar results.

TWO spun off Granite Point in the fourth quarter of 2017 and therefore data related to that transaction was adjusted in the table to compensate for the event.

Disclaimer: This material is subject to change without notice. This document is for information and illustrative purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action, including without limitation as those terms are used in any applicable law or regulation.