"Operation Twist”, recently implemented by the Fed, is designed to drive the long-end of the yield-curve down by taking $400 billion in maturing short-term Treasury investments, held in its inventory, and investing those proceeds in long-term securities—including mortgage-backed bonds. We wanted to review the impact of “Operation Twist” on the those CEFs that are categorized as “USMrtgBndFnds”.
Mixed Impact: We believe that “Operation Twist” should have a mixed impact on the MBS markets and those CEFs that traffic in this asset class. We believe it has created a bifurcation of valuation.
While lower yields will enhance the value of fixed-income securities—like MBSs, the same lower long-term interest rates have created an initial surge in mortgage refinancing. This refinancing generates loan prepayments on mortgages backing those MBS securities. This will have a negative impact on such investments returns because the investment in the high yield mortgages will be paid off leaving the investor with lower reinvestment returns or reinvestment. This trend would be exacerbated for those mortgage backed bonds that were purchased at a premium.
Bifurcation: We compared those CEFs classified as “USMrtgBndFnds” with total assets greater than $100 million to the iShares Barclays MBS Bond Fund (MBB) ETF and the iShares Trust Barclays 7-10 Year Treasury Bond Fund (IEF) [as the average mortgage is outstanding 7 years] in an effort to determine how investors were interpreting “Operation Twist” on these related investments.
Limited Field: Of the seven CEFs classified as USMrtgBndFnds, only three had 2/3’s of their respective portfolios in residential mortgages and/or mortgage backed securities. Others in this category were either heavily invested in non-mortgage asset backed bonds (“ABS”) or commercial mortgage backed securities (“CMBS”) (See table below).
(Click charts to expand)
Valuations: As the chart illustrates, BlackRock Income Trust (BKT) “green” tracks more with closely with IEF “red” and MBB "dark blue". The chart further demonstrates the declining fortunes of both Nuveen Mortgage Opportunity Trust (JLS) “purple” and Nuveen Mortgage Opportunity Term Fund (JMT) “light blue”.
Comparisons: BKT is invested more conservatively in mortgage-backed agency paper. Its current annualized monthly distribution yield is 6.1% and it is trading at a discount to NAV of 10.2%. Its expense ratio is 1.1%. It has $606 million in total assets with moderate leverage of 15.3%. BKT increased its monthly distribution rate by 37.7% in June of this year.
Contrast: In contrast, both JLS and JMT focus on the high-yield mortgage backed securities. Each has invested a portion of its funds (approximately 25%) in the Private-Public Investment Program (“PPIP”) set up by the US Treasury. The purpose of the PPIP was to induce private capital, in conjunction with the employment of public leverage, to acquire illiquid legacy assets from financial institutions going through restructuring.
Focus on JLS: The JLS current monthly annualized distribution is 10.0% and it trades at an 8.6% discount to its NAV. JLS has approximately $400 million in total assets. While its balance sheet isn’t leveraged, it is assuming leverage with its investments in the PPIP.
One would speculate that borrowers with mortgages with higher interest rates would have a significant incentive to refinance their mortgages. However, in many cases such borrowers were of higher credit risk and typically place the minimum of down payment on their homes. With the drop in housing values, many of these homeowners are underwater with regards to loan-to-value ratios. Consequently, with banks demanding more collateral to make new loans, the ability of those borrowers to refinance their current mortgage may be limited.
Consequently, we believe that relative to BKT, JLS appears to have been oversold.
Caveats: Our conversation with Nuveen provided little insight into the thinking regarding "Operation Twist" and its impact on mortgage securities as an asset class. Its position was to characterize any implications drawn from the program as speculative.
Disclosure: I have traded JLS off and on and may do so again. Currently, I have no position.
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