Capstead Mortgage Corporation (NYSE:CMO) invests almost exclusively in short duration Adjustable Rate Mortgage, or ARM, agency securities. There are three attributes in this statement that signify Capstead Mortgage Corporation (NYSE:CMO)’s highly conservative strategy.
First, Capstead Mortgage Corporation (NYSE:CMO) invests only in MBS securities that are guaranteed by the government or government sponsored entities, thus nullifying any credit risk. Secondly, Capstead Mortgage Corporation (NYSE:CMO) invests almost exclusively in ARM securities. The price of ARM securities, and thus Capstead’s book value per share, is less sensitive to changes in interest rates as compared to fixed-rate MBS. Thirdly, even within ARM securities, Capstead focuses on short duration securities in order to further reduce sensitivity to rising interest rate.
Second-quarter highlights
As a result of its conservative strategy, Capstead reported stable second-quarter earnings and a relatively small decline in book value per share. Capstead reported a core EPS of $0.27 for the quarter, as compared to $0.31 in the first-quarter. The company’s net interest spread declined by 15 basis points to an average of 1.00% for the quarter. The decline in this spread was largely due to a lower yield on the MBS portfolio as a result of an increase in prepayments; the average Constant Prepayment Rate, or CPR, jumped to 22.74% for the quarter as compared to 19.65% in the previous quarter.
Most importantly, Capstead’s book value per share declined 5.9% sequentially; however, only 3.8% of the decline is attributed to the changes in pricing as a result of rising rates. The other 2.1% of the loss was due to the redemption of the high-cost perpetual preferred shares, the proceeds of which were used to issue lower-cost perpetual preferred capital. The company’s management expects this loss in book value per share to be fully recovered in around three years’ time.
It’s all relative …
While Capstead’s results don’t look spectacular in isolation, I believe that the company has done an excellent job in preserving its book value at a time when its peers are struggling.
Hatteras Financial Corp. (NYSE:HTS), one of Capstead’s closest competitors, also invests in agency hybrid ARMs. In its second quarter earnings results, Hatteras Financial Corp. (NYSE:HTS) reported an EPS of $0.66 as compared to $0.62 in the first quarter. The company’s net interest spread declined by 18 basis points sequentially to 0.93% for the quarter as the CPR increased from 19% in the first quarter to 20.8% in the second quarter.
The real shock from Hatteras Financial Corp. (NYSE:HTS) came in the form of a sharp drop in its book value per share, which dropped by a whopping $6 per share, or 21.3% sequentially, to $22.18 by the end of the quarter. The sharp decline in book value was a result of the rapid decline in the longer duration hybrid ARM prices in the second half of June as mortgage basis for such ARMs widened.
In contrast to Capstead Mortgage and Hatteras Financial Corp. (NYSE:HTS) that invest in hybrid ARMs, American Capital Agency Corp. (NASDAQ:AGNC) is an mREIT that invests mostly in seasoned long duration fixed rate MBS securities with low prepayment risk. This strategy exposes American Capital Agency Corp. (NASDAQ:AGNC) to a lot of interest rate risk, but its second quarter results were better than investors’ worst fears.
In these results, American Capital Agency Corp. (NASDAQ:AGNC) reported a comprehensive loss per share of $2.37 as compared to a comprehensive loss per share of $1.57 in the previous quarter. The company’s net interest spread declined by 12 basis points to 1.59% for the quarter; however, unlike with Hatteras Financial Corp. (NYSE:HTS) and Capstead, the drop in interest spread for American Capital Agency Corp. (NASDAQ:AGNC) was due to a higher cost of capital rather than an increase in prepayments.
In order to decrease the duration of its portfolio, American Capital Agency Corp. (NASDAQ:AGNC) swapped out of the more troubled 30-year fixed rate MBS and into 15-year fixed rate MBS. Active portfolio management coupled with effective hedging meant that American Capital Agency Corp. (NASDAQ:AGNC) was able to limit its book value decline to 11.8% from the first quarter, which is much better than that of the theoretically more conservative Hatteras Financial Corp. (NYSE:HTS).
Foolish take
Agency mREITs suffered sharp book value losses across the board in the second quarter due to rising interest rates and widening mortgage spreads. However, Capstead Mortgage was a star performer that survived the bloodbath in this space. Capstead has a dividend yield of over 10%, is trading at a 6% discount to its second-quarter book value, and has demonstrated that it can preserve its book value in a highly volatile interest rate environment. Due to these factors, I would rate Capstead Mortgage a buy.
I would rate American Capital Agency a hold since its management has done an excellent job in limiting the book value loss in very tough conditions. This gives me confidence that the management has the capacity to deal with tough circumstances. However, I’m not at all convinced by Hatteras Financial’s book value decline, especially since it follows a relatively conservative strategy, and would recommend getting out of any long positions in this name.
The article This mREIT Offers Book Value Preservation and a 10% Yield originally appeared on Fool.com and is written by Zain Zafar.
Zain Zafar has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Zain is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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