Mortgage REITs are among the favorite asset classes for income investors thanks to their attractive dividend yields as well as modest capital appreciation over the past few years. However, with an uncertain interest rate environment thanks to the ever looming threat of the Fed’s tapering of QE3, mREITS are giving investors some sleepless nights. A few weeks ago, I had stated that Capstead Mortgage Corporation (NYSE:CMO) is the safest bet in such an environment, and Capstead Mortgage Corporation (NYSE:CMO)’s second quarter earnings results have further affirmed my conviction.
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.
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.