PFF - Extreme Market Failure In The Mortgage REIT Sector

2023-04-04 19:09:14 ET

Summary

• Wild swings in relative share prices leads to a dramatic change in relative values.
• Exploiting these opportunities enhances total returns and dividend income over time.
• This weekend saw a staggering number of extreme failures in market prices.
• We called them out before the market opened to help investors identify the right shares to swap.
• Due to partial corrections by Monday morning, many of the opportunities had already shrunk significantly.

Get ready for charts, images, and tables because they are better than words. Well, not this week. This week those things are all missing. The ratings and outlooks we highlight here come after Scott Kennedy’s weekly updates in the REIT Forum. Your continued feedback is greatly appreciated, so please leave a comment with suggestions.

We don’t chase yield. It isn’t our thing. We do find quite a few opportunities in the higher-yielding sectors though. Many of those opportunities are for trading, much to the dismay of investors who want to hold shares for double-digit yields while ignoring price movements.

Yet we also find some other opportunities. When we enter the preferred shares, we have a bit of a hybrid strategy. We’re comfortable holding the shares for income, but we’re also comfortable trading them when we see a shift in relative values. When the market is calm, we only get a few of those opportunities and we’re usually only capturing an extra 2% in value. However, when the market gets more volatile, we can find prices disconnecting even further.

This is great for investors. The shares already carry very high dividend yields, generally in the 8% to 11% range. The opportunity to add growth by trading back and forth enhances the expected return with minimal risk (just execution risk for making the trades). Much of the execution risk can be mitigated by checking live prices for the bid and ask and waiting for price failures large enough to permit some slipping in the execution prices.

I want to share some of the highlights from our April Portfolio Update (paywall if you don’t have The REIT Forum). Bolding within the quotes also was present in the initial publication.

These are two direct quotes (not the full article) from the article we published late Sunday night:

We don’t currently have RITM-B ( RITM.PB ) because we already took profits on it. However, if we did have it, trading from RITM-B at $21.54 to RITM-D ( RITM.PD ) at $19.70 would be a clear improvement. That spread of $1.84 is just way too large. RITM-D is the better bargain. Investors should sell RITM-B to buy RITM-D if they can get a spread near $1.84.

MFA-B ( MFA.PB ) at $19.24 is much too expensive relative to MFA-C ( MFA.PC ) at $17.04. A spread of $2.20? Crazy. Investors should sell MFA-B to buy MFA-C if they can get a spread near $2.20.

We also wrote:

NLY-G ( NLY.PG ) at $23.81 to NLY-F ( NLY.PF ) at $23.61 is a hilarious homerun trade. Both shares are floating. Would you like to get a materially higher floating spread (that's NLY-F)? But what if it came with paying a lower share price? Pocket $.20 today and then pocket about an extra $.20 in dividends per year for as long as both shares are outstanding. That’s absurd. That’s a good option for where to throw my cash also. NLY-F should pop higher. Stripped yield at 10.4%. Current 3-month floating rates would have it reset even higher, though in late 2023 or in 2024 at the latest we should see some declines in short-term rates. Investors in NLY-G would dump NLY-G to buy NLY-F if they can get a spread near $.20. Let’s be realistic, though, even if the investor pays out $.20 instead of pocketing $.20 on the trade, they would still be getting a very good deal. NLY-G should never be priced above NLY-F. Can I pound this point home harder?

PMT-A ( PMT.PA ) at $23.83 is a bit too expensive compared to PMT-B ( PMT.PB ) at $23.00. The margin isn’t as laughable as the other shares we’ve highlighted in this section , but it's still material. PMT-A will float one quarter sooner. Yay. In the one year before the floating rate, it also will pay out a few extra pennies in dividends. Like $.02 to $.03. That’s it. When both shares float, PMT-B gets a slightly bigger spread. Would you pay $.83 to get back an extra $.02 to $.03 and float one quarter sooner, then have a lower floating spread indefinitely? Raw deal. The floating rate absolutely is going to add $.80 in one quarter. Investors may get this trade wrong by an even larger margin at some point, but the risk/reward clearly favors PMT-B over PMT-A. I would also point out that PMT-A traded below $20.50 as recently as March 24th. That’s quite a jump.

EFC-B ( EFC.PB ) at $21.31 into EFC-C ( EFC.PC ) at $21.30 is a homerun. Don’t expect that spread to last. That’s insanity. EFC-C is a materially better share. Investors in EFC-C have to wait an extra 15 months for the rate to reset (4/30/2028 instead of 1/30/2027), but the stripped yield is 10.13% instead of 7.34%. The investor in EFC-C is getting back a material amount of additional cash while they wait. When EFC-C was introduced, we blatantly mocked the valuation of EFC-C . At that point, EFC-B was $19.26 (about $2.06 cheaper than today) and EFC-C as $24.55 (about $3.25 above today’s price). Those price spreads ignore dividend accrual because we’re talking about a difference greater than $5.00. One share went up more than 10%, the other share went down 13.2%. That’s an absolutely massive spread.

If investors get a deal anywhere remotely close to equal prices on trading from EFC-B into EFC-C , they should stop and do a little dance after getting execution. When we calculated all the cash flows out, we suggested that an efficient gap would be about $2.40 to $2.43, and we figured the market would settle on a gap around $3.00 to $3.15. Right now, the gap is negative $.01. If that gap explodes from negative $.01 to positive $1.00 (EFC-C costing $1.00 more than EFC-B), it would still be an outstanding deal.

Here’s the price chart set to one bar per hour:

Notice something absurd happening on March 31? Yeah, that's a complete and utter market failure. Some entity was probably forced to buy EFC-B as part of an index. It wasn’t their money, so who cares? They simply run the passive ETF and follow the index. The ETF investors lose some money as an awful trade is placed on their behalf. Big deal. The manager still gets the management fee and they simply point out that the index didn't perform all that well since the Index also is buying EFCpB at $21.31. This is why we pick individual positions instead of sitting in an index fund and paying someone to waste our money on producing inferior results.

These preferred share opportunities were so extreme that I felt it necessary to finish this article tonight so subscribers would have it before the markets on Monday. Many members will have positions in at least one of these shares. We will most likely see several of these opportunities shrink significantly on Monday. However, whichever ones remain should provide an enormous amount of alpha for the members who get those trades. When trying to move large positions for a trade between shares, we often suggest moving part of the position in each trade rather than trying to get it all in one go. Liquidity can be low. That’s part of why these opportunities can develop.

Hopefully, this section has been very clear about which way we would want to move between any two shares that were listed together. I apologize in advance for any typos or grammatical mistakes missed due to having less time to proofread the piece. There will almost certainly be some. However, I decided the value of speed in this instance was greater than the value of getting each section worded perfectly.

Of course, most shares have already been partially corrected. They were partially corrected the moment the market opened on Monday. However, the commentary here gives some extremely specific price spreads where we’ve established a strong opinion about which share is the better value.

Understanding these price spreads is important because it helps an investor figure out which share is a better deal. That can be used when buying shares and when trading between them. We highlight these disparities because the market creates opportunities for swapping between shares to get a better price. Those swaps enable investors to combine the high yield on the shares with growth from swapping back and forth based on prices.

Here’s a table of how those ideas are working out so far:

Not bad for a couple of days. Because the market partially corrected before the opening, in many cases, it wasn't possible to achieve 100% of the outperformance. I want to make sure that's clear, because it's important. When we place trades, we use real accounts. When the market corrects before shares can be traded, we don't earn a profit from that. That's only possible if someone trades in a spreadsheet instead of a real account.

Regardless, the disparity was still dramatic and demonstrates the importance of understanding relative values.

Finding Our Charts

I posted all the charts as part of another full article (covering some mortgage REIT preferred shares) on my website.

Strategy

Our goal is to maximize total returns . We achieve those most effectively by including “trading” strategies. We regularly trade positions in the mortgage REIT common shares and BDCs because:

1. Prices are inefficient.
2. Long term, share prices generally revolve around book value.
3. Short term, price-to-book ratios can deviate materially.
4. Book value isn’t the only step in analysis, but it's the cornerstone.

We also allocate to preferred shares and equity REITs. We encourage buy-and-hold investors to consider using more preferred shares and equity REITs.

Performance

We compare our performance against four ETFs that investors might use for exposure to our sectors:

The four ETFs we use for comparison are:

When investors think it isn’t possible to earn solid returns in preferred shares or mortgage REITs, we politely disagree. The sector has plenty of opportunities, but investors still need to be wary of the risks. We can’t simply reach for yield and hope for the best. When it comes to common shares, we need to be even more vigilant to protect our principal by regularly watching prices and updating estimates for book value and price targets.

Ratings : This article was all about relative values.

For further details see: