The number one complaint I hear from fixed-income investors is that today’s low-interest-rate environment has made it nearly impossible to find safe sources of income. The dividend yield of most equities has fallen drastically since 2008, and the flattened yield curve has made long-term bonds extremely unattractive be it in Treasuries or in corporate bonds.
In my opinion, the risks facing fixed-income investors are higher than most believe. Investors have come to expect chronically falling inflation to boost the principal value of their investments. Indeed, low inflation has pushed interest rates down, but when inflation expectations rise as they did in 2017, they may be in for a nasty surprise.
To me, the best strategy today for fixed income investors is to look for investments that are shielded from inflation and interest rate risk. If you recall, the Long-Term Treasury Bond ETF (TLT) lost 8% of its value in three days following an inflation scare after Trump was elected. While default risks on Treasury bonds are low, inflation “shock” risks are very high. Frankly, I think more shocks like that could be just around the corner.
There is one generally unloved asset class that is largely shielded from this risk and pays an extremely high yield today: mortgage REITs. This asset class was the “big bad bear” in 2007 as it is ground zero for mortgage-backed securities, but because they profit off of the spread between mortgage rates and lending rates, they carry far less interest rate risk than most yielding investments. Also, because investors lost so much in 2008, they remain incredibly cheap compared to other assets despite huge increases to solvency and a very healthy housing market.
To illustrate, take a look at the dividend yield of the Mortgage REIT ETF (REM) vs. that of utilities (XLU), consumer staples (XLP), long-term Treasuries (TLT), preferred equity (PFF), junk bonds (JNK), and equity REITs (VNQ):
As you can see, the yield on all of the other major assets fixed-income investors buy has declined dramatically over the last decade while that of mREITs has remained unchanged.
While mREITs are more volatile than the others, I believe they are structurally less risky because they carry far less inflation/rate sensitivity. Even more, U.S. households have become extremely solvent and their demand for mortgages is likely to increase and potentially boost mortgage rates over the coming months and years.
Let’s dig into REM and see the specific value opportunity it provides today.
The iShares Mortgage Real Estate ETF
The ETF had a very unfortunate beginning as it was launched at the height of the market in spring 2007 and subsequently lost about 75% of its value. Since then, it has recovered most of those losses and has had substantial performance. Take a look at the fund’s total returns (which include dividends) vs. its total assets under management:
As you can see, the ETF was highly volatile during the first five years after the crash and suffered many major sell-offs. However, since 2016 volatility has remained low and performance has been exceptional. Interestingly, total AUM has not kept pace with performance which may be due to the fact that investors fear we are at the end of an economic cycle and may be headed for another property crash. As I’ll demonstrate in the following section, those fears do not appear to be well-founded in the data.
Let’s go over a few important key metrics to keep in mind. The fund currently pays a high dividend yield of 8.8% and currently has a price-to-cash flow ratio of 7.9X which implies the yield could be increased to 12%. The average mREIT in the fund is trading near book value as the ETF currently has a weighted average “P/B” ratio of 1.07X. Even more, it has a fair expense ratio of 48 bps and offers solid diversification with a beta of only 0.56 to the S&P 500.
Overall, these statistics demonstrate that the ETF has no major red flags and is likely undervalued based on its high dividend yield. As you’ll see, the current economic backdrop may actually cause that dividend yield to increase over the coming months.
REM to Gain from Rising Mortgage Spreads
Mortgage REITs business model is relatively simple. Borrow at low-interest rates (often at 5-10X leverage) and invest in residential and commercial mortgage-backed securities as well as whole loans.
Often, the mREITs with higher leverage have more substantive investments in ultra-low-risk agency-backed mortgages. Usually, these are Ginnie Mae securities that carry the same default risk as the Treasury since they are secured by the “full faith and credit” of the U.S. government. Many are also backed by Fannie Mae (OTCQB:FNMA) which carries a negligibly higher risk in case the company goes under after it is (finally) re-privatized.
Accordingly, the dividend yield of REM is essentially a function of the spread between mortgages and short-term loans. See below:
The extremely thin spread today is the primary culprit for recent poor performance in the market. While this means “lower” dividends in the short-run, thin spreads usually beget larger spreads. Take a look at how cyclical the spread is below:
As you can see, the spread historically rises from its current level. It has been on a long slow decline since 2010 as mortgage rates have been held down by the Fed’s massive MBS purchasing following the crash. Now that the Fed is not holding mortgage rates down but is lowering the short-term rate, the spread is likely to steepen from here.
There are many fundamental economic signals that agree. First, after the major debt deleveraging, the average American is extremely solvent and home prices are cheap by historical standards (mainly outside of coastal states).
Take a look at U.S. average new homes sales price and debt service payments over disposable income:
With interest rates this low, homes are incredibly cheap as a ratio of income and the average American is borrowing far below their limit. In other words, demand for mortgages is likely to rise and push up rates, and with service payments this low, default rates are likely to remain low for years.
Strength is also apparent in rising building permits supported by historically low vacancy rates:
With the vacancy rate at a roughly 40-year low and building permits coming out of a depression, demand for mortgages is likely to stay very strong. While I’m not too bullish on the coastal states’ property market, I think it is fair to say that home values could climb much higher in the rest of the country. If you’re looking at individual mREITs, you may be best looking at those buying mortgages outside of California and New York.
The Bottom Line
Mortgage REITs appear to be one of the last income-paying asset classes that remain cheap. This is most likely because investors have been conditioned to cringe at the word “Mortgage-Backed Security” and place an extremely high risk premium on the lenders.
In my opinion, the current economic backdrop is very supportive for the mortgage market. Spreads have hit a historical bottom, new home sales are likely to rise, and household insolvency risks are at multi-decade lows. Even more, the mortgage underwriting process and leverage levels of mREITs have removed much of the “hidden” risks in the asset class.
While I’m not entirely bullish on the stock market, I am on mREITs and believe REM is a strong long-term buy at the current price.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in REM over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.