Tag Archives: reits

REM And The mREITs

Summary The mREIT sector faces a few headwinds. Book value for most mREITs fell hard in the second quarter, but the prepayments were a much larger economic problem than the widening of spreads. Wider spreads are painful as they come into existence, but they are healthy. The iShares Mortgage Real Estate Capped ETF (NYSEARCA: REM ) can be viewed in a few manners. Some people may analyze it as a traditional ETF filled with companies that have a similar line of work, while others may try to tackle it at a more macroeconomic level. In my opinion, a macroeconomic view of REM makes sense. While REM is an ETF, it is filled with mREITs which in turn act as option-embedded leveraged bond funds. Investors choosing to buy REM are most likely doing it for the yield on the ETF rather than for capital appreciation, however it is wise to understand the factors that will influence the level of dividends that can be paid by the underlying securities. The Underlying Securities REM’s top 10 holdings are displayed below: (click to enlarge) The top 2 holdings, Annaly Capital Management (NYSE: NLY ) and American Capital Agency Corp. (NASDAQ: AGNC ), make up just over 26% of the portfolio. These mREITs frequently will at least modify their exposures to the MBS market. For instance, Annaly Capital Management recently announced that they would begin diversifying into non-Agency MBS. That sounds like a good move since it should reduce volatility that comes from having a portfolio that was too heavily focused. American Capital Agency Corp. on the other hand decided to modify their strategy lately by reducing leverage due to expectations for movements in prices that would negatively impact mREITs with higher levels of leverage. In short, investors should recognize that each mREIT may be slightly different from one quarter to the next in their holdings which causes the overall the risk profile to change for each security. Despite having a fairly heavy focus on the top few securities there is still a fairly reasonable amount of diversification within the ETF. Therefore, investors will want to consider what factors can influence the performance of the entire sector. Sector Headwinds Generally speaking the mREITs will own long-term loans in the form of MBS and use a moderate amount of hedging closer to the middle of the yield curve. They will finance the position with short-term borrowing. For an mREIT that is going to hedge heavily the difference between the yield on their long-term MBS assets and the rate they pay on their interest rate swaps is critical in determining how much income the mREIT can make. For an mREIT that does substantially less hedging, the short-term rates on their repo agreements are extremely important. Going light on hedges means more risk but higher returns if the repo rates stay low. The risk of short-term rates increasing materially over the next few years is a real challenge to mREITs. If they hedge out most of the risk with heavy use of interest rate swaps, their potential income is severely limited. If they do not hedge heavily against the risks then increases in repo rates could hammer their net interest income, while declining values of MBS (yields up, prices down) would hammer their book value. The Ugly Beast of Refinancing A major challenge for mREITs has been the availability of refinancing options because the loans are sold to the mREITs at a premium to par which means a very early repayment of the loan results in material losses of book value for the mREITs. Refinancing is an ugly negative sum game. The home owners win but the holder of the loan loses. If this were simply an even trade off, it wouldn’t be so bad. Unfortunately there is real work involved and someone has to pay for that work. Someone has to oversee and approve the refinancing of the debt. The payments must be handled and the forms signed. Labor has a real price and it must be baked into the MBS in one manner or another. If refinancing was severely reduced I would believe it would be extremely favorable for mREITs. Spreads Many mREITs had a terrible second quarter in large part due to MBS rates increasing more than interest swap rates. When the MBS rates are increasing the mREIT has a loss on the value of their assets. When the swap rates increase the mREIT records a gain on their derivative that helps to offset the loss on the value of the assets. When the MBS rates are increasing more than the swap rates the result is that many mREITs will record substantial losses in book value. When these spreads widen the mREITs report a loss in book value. Are Wider Spreads Worse? If a widening of the spreads creates a loss of book value, does that make wider spreads worse? Imagine yourself contemplating launching your own one man (or woman) mREIT. You’re contemplating investing in MBS that yield 3.5% and financing it with short-term debt. However, you don’t want the interest rate risk so you could use an interest rate swap to receive the short-term rate and pay a medium-term rate. You would receive the yield on the MBS, pay the short-term rate on your financing, receive the short-term rate from your swap, and pay the medium-term rate on the swap. The two middle steps are effectively canceling each other out so that you would expect to receive the MBS yield and pay the swap rate. If the asset yields 3.5%, would you rather pay 1%, 2%, or 3% on the swap? Hopefully in this scenario you can recognize that you want to pay the lowest rate possible, so 1% would easily be the winner in this scenario. Unfortunately, I’ve met many investors in mREITs that do not understand this mechanism. They become so caught up in the complexities that they miss out on the simple parts of the bigger picture. When spreads were widening during the second quarter it meant that asset yields went up by more than the swap rates. Since the mREITs were already locked into swap rates and MBS assets they were reporting a loss on book value. However, if you wanted to invest a new dollar into this activity it would have been more favorable to do it at the end of the second quarter than at the end of the first quarter. Conclusions The mREIT sector deserves a smaller discount to book value at the end of the second quarter than at the start of the first quarter. The mREITs lost book value from widening spreads, but the wider spreads provide the room for better levels of interest income. If spreads widened again it would mean more book value losses, but I would be willing to pay a value closer to book value when buying mREITs. If refinancing was curtailed, I would expect lower levels of prepayments, lower amortization charges, and consequently better yields on MBS assets. A smaller discount to book value at the end of Q2 does not mean a higher price because the book value we are discounting from is also lower. In my opinion, the sector had good reason to fall after getting hammered by prepayments however the fall was more substantial than I would have considered reasonable. When book value falls on spreads becoming wider and the discount to book value increases at the same time, I see a market failure that makes the mREITs more attractive. I recently added to my position in Dynex Capital (NYSE: DX ) because I felt the discount to book value given the movements in rates was not warranted. Disclosure: I am/we are long DX. (More…) 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. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.

EXG: The Distribution Is Your Return

Eaton Vance Tax-Managed Global Diversified Equity Income Fund is a mouth full of a name. It isn’t a bad fund, but your return is largely coming from distributions. That may not be a problem for you, but it is something you’ll want to keep in mind. A reader recently mentioned the Eaton Vance Tax-Managed Global Diversified Equity Income Fund (NYSE: EXG ), a fund I haven’t written much about yet. Since I have examined some of this fund’s brethren at Eaton Vance, I figured it was time for a deep dive on EXG, too. At the end of the day, it’s a mixed bag. What’s it do? EXG is a globally diversified option income fund. However, global primarily means developed markets. So the United States and Europe make up roughly 90% of the fund. And the fund’s Asian exposure is primarily in Japan. This is probably the best course of action for a fund that intends to sell options on its holdings with the goal of producing enough current income to support a managed distribution policy. You just need to keep in mind that emerging markets don’t play much of a role here. In addition to investing globally and writing options, the fund also strives to reduce taxes by using such techniques as tax loss harvesting and extending holding periods to at least a year. On one level it’s nice to know that these are a key focus for the fund, on another it seems like such strategies should be the norm for every fund, closed-end or open-end. But I don’t consider this a deal breaker or maker for EXG, it’s just another fact to know. What your return looks like Looking at total return, EXG isn’t a bad fund at all. The fund’s annualized return was 10% over the trailing three- and five-year periods through June. That trails the S&P 500 index and the Vanguard Global Equity Fund Investor Shares (MUTF: VHGEX ) over those spans. However, investing in the S&P or VHGEX would have left investors with yields in the low single digits. EXG’s distribution yield is in the high single digits. So there’s a trade off. And that’s an important thing with EXG. The distribution, especially over the last few years, has been the main source of your return. For example, the fund’s net asset value was $12.30 at the start of the company’s 2010 fiscal year (years end in October). It fell to $10.22 by the end of fiscal 2011 before rebounding to $10.82 at the start of fiscal 2014. It has since been in a downtrend again, recently hitting $10.50 or so. The recent NAV compared to $12.30 isn’t a flattering comparison. However, since 2011, the NAV has been fairly consistent. That, not surprisingly, coincides with a trimming of EXG’s distribution. Effectively the distribution was eating away at NAV, basically destructive return of capital, and Eaton Vance took steps to change that dynamic. For the fund that was a good decision and has clearly been an important part of stabilizing the fund’s NAV. But the second take away here is that the distribution has basically provided nearly all of the return the fund has offered in recent years. If you are looking for income that may not be a bad thing. However, EXG’s 9%+ distribution yield pretty much means you shouldn’t expect much capital appreciation from this fund. And if you are looking for a mix of income and capital appreciation you’re probably best looking elsewhere. Some more things to consider EXG’s expense ratio is roughly 1.07%. While that’s expensive compared to Vanguard’s products (VHGEX, for example, has an expense ratio of around 0.6%) and exchange traded funds, it’s not outlandish for an actively managed fund that invests globally. So it isn’t cheap to own, but nor is it expensive. Interestingly, EXG’s standard deviation is below that of VHGEX by nearly 10% over the trailing five-year period. However, that makes sense based on the fund’s use of option. Essentially, they will help protect a fund from losses because option premiums will offset stock declines. To whit, EXG was down roughly 27% in 2008. VHGEX declined nearly 47%. But options will also hamper returns on the upside, too, since positions with options written on them can be called away. Which is why in 2009 EXG advanced 23% and VHGEX was up a more impressive 33%. EXG’s trend of smaller losses and smaller gains is the norm between this pair. That said, if you are worried about the level of the world’s stock markets, EXG is a way to stay in the game while at least potentially protecting yourself from a severe downdraft. Good for some, not for others At the end of the day, I think EXG is an OK fund. I’m not so excited about it that I think everyone should own it, but for the right investor it could make a lot of sense. The big thing to remember, however, is that the yield is your return. That could turn into an issue if there’s another big market decline. With the NAV stuck in neutral for several years, a market-driven decline in NAV would make it harder to sustain the current payout. So, if you do step aboard here for global exposure, make sure to watch the NAV closely. Eaton Vance has proven willing in the past to trim distributions to protect NAV and I would expect them to do so again. As for premiums and discounts, EXG’s recent discount is narrower than its three- and five-year averages. Thus it isn’t a good candidate for investors looking to play closed-end fund premiums and discounts. So, for income investors looking for global exposure, EXG is worth a look. That’s especially true if you are concerned about the potential for a global market sell off. But EXG probably shouldn’t be the only fund you consider. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.

Closed End Funds: Total Return Or NAV Return?

Closed-end funds are simple in concept, but complicated in practice. The big confusion comes from the frequent focus on distributions. While I believe distributions are strength for CEFs, they can also be a weakness. Closed-end funds, or CEFs, are something of an unloved stepchild in the pooled investment industry. Open-end mutual funds and exchange traded funds are the fair-haired children. But the lack of love paid to CEFs is really part of the appeal. Only you have to come to terms with how you want to measure CEF success. Returns When it comes to tracking pooled investment products you generally look at total return. This means including reinvested distributions into the performance equation. It makes sense to do this since CEFs, open-end mutual funds, and exchange traded funds are pass-through investments, meaning they have to send along any income or capital gains to shareholders. Calculating returns as if those distributions were put back to work is a simple method for including these distributions into returns and is a basic industry norm. Indeed, total return facilitates comparing funds to each other on an apples to apples basis. So, when looking at a CEF, you should consider more than just price performance. In fact, many CEFs focus on paying out large distributions. That leaves their net asset values, or NAVs, stagnant even though investors are receiving notable returns. A good example is Eaton Vance Tax-Managed Buy-Write Income Fund (NYSE: ETB ). ETB’s NAV at the start of 2010 was $15.59 a share. At the end of 2014 it was $16.31 a share. That’s an increase of 4.6% over five years. On the surface that sounds pretty abysmal. However, the fund distributed $6.98 per share over that span. Including this information completely changes the equation. And that’s why it’s important to look at total return and not just NAV. Complicating this is that CEFs trade on exchanges like stocks, but operate like mutual funds. And that leads to premiums and discounts to net asset value. Your results will be based on the market price, but when examining how a CEF is doing, you’ll want to look at NAV performance. Why? Market prices for CEFs are based on supply and demand, meaning investor sentiment rules the day. NAV is the actual performance of the portfolio. It’s a truer picture of management’s ability. But don’t forget NAV That said, you can’t forget about NAV and just look at total return. And distributions are, again, the reason. One of the big fears in the closed-end space is so-called destructive return of capital. This happens when a CEF pays out distributions while its NAV is falling. Over short periods of time this can provide shareholders with steady income, but over longer periods it can destroy a fund’s capital base and, thus, it’s ability to maintain distributions. On this front, take a look at Dreyfus High Yield Strategies Fund (NYSE: DHF ). In March 2011, the fund’s NAV was $4.08 a share. (The fund’s fiscal year ends in March.) By March 2015 the NAV had fallen to $3.84 a share. It paid out $2.22 a share in distributions over that span, producing a decent total return. However, looking beneath that, the distribution has fallen in each of the last five fiscal years. DHY’s distribution has gone from $0.52 a share in fiscal 2011 to $0.36 a share in fiscal 2015. So, yes, the fund’s trailing total returns aren’t bad. Yes, it still offers a notable yield. But the fund is getting smaller and smaller and so is the distribution. There are multiple reasons for this. One is that DHY is a high-yield fund dealing with an unusual low-rate world. So as bonds mature they are replaced with lower yielding fare. That said, with fewer assets in the fund, DHY is also hampered by the not so small fact that it can’t buy as many bonds as it could just a few years earlier. So this example shows that there are times when total return isn’t enough of a picture to decide on a CEF investment. Income for life The need to examine both total return and NAV is particularly important if you are an investor looking to live off the income your portfolio generates. In this situation you won’t be reinvesting your dividends, you’ll be spending them. And, thus, total return may be the best way to compare funds to each other, but it won’t be indicative of your portfolio’s performance or, more to the point, how long your money will last you. If your capital continues to decline over time because your CEFs pay out notable distributions that you spend while their NAVs are falling, you are in a much weaker position than total return alone might suggest. Which is exactly why destructive return of capital is such a buzz phrase. CEFs are a complex space and require a bit more thought than open-end mutual funds or exchange traded funds. And while their distributions often make them stand out from other pooled investment vehicle choices, you can’t just look at them from one angle and be done with it. So, look at total return and watch NAV. The stories each metric tells is important. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.