Despite somewhat of a bounce-back in July, there remains significant opportunities across various residential sub-sectors.
1) Many mortgage REITs are trading at sizeable discounts to book value with high single digit/low teens dividend yields.
2) Mortgage servicers are also still trading at significant discounts to book value and have balanced businesses that should perform well in a range of interest rate scenarios.
Q2 earnings dispelled many market participants fears of catastrophic write-downs and liquidity issues. As we have said, liquidity issues for mortgage investors are unlikely since the leverage profile is much safer versus the time period leading up to the pandemic. Financing is now longer-term with less reliance on short-term repo borrowing which is subject to ongoing margin calls. Many mortgage REITs learned their lesson in 2020 (for now) which has been beneficial over the last few months as asset volatility has obviously been elevated.
Q2 earnings also confirmed our belief that “servicing focused” mortgage originators like Mr. Cooper (COOP) would actually grow book value in the quarter as their servicing rights are marked up. On Wednesday, COOP reported that it grew tangible book value (TBV) by 5% in Q2 and repurchased $100mm worth of stock. COOP’s stock was up 11% for the week and still trades at a ~20% discount to TBV not counting a potentially valuable asset in their foreclosure auction exchange.
Read more about Mr. Cooper:
Here (AlphaWatch)
Here (BusinessWire)
Here (Earnings Call)
We still think the best opportunities in the mortgage/real estate security universe are in residential mortgage-related common equities and short-term corporate bonds. From a risk/reward standpoint, corporate bonds issued by mortgage REITs and servicers are probably at the top of our list. That is because yields are still in the high single digit/low teens with low duration and very little default risk. We also believe retail investors have difficulty sourcing this type of paper on their own (partially because many corporate bond issuances are 144a which have high net worth requirements). We are also monitoring opportunities in legacy RMBS and CMBS (although we are being very cautious on commercial real estate risk).