This mREIT Disappoints Analysts
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Capstead Mortgage (NYSE: CMO) disappointed analysts in general when it reported its results for the fourth quarter of the prior year. The bottom line of $0.31 per common share was $0.02, or 6.1% behind the mean expectation of $0.33 per common share. This is compared to $0.35 of EPS at the end of the linked quarter. The company paid a $0.30 dividend for the fourth quarter, yielding over 9%.
Capstead Mortgage, a $1.2 billion mortgage REIT invests largely in adjustable rate residential mortgage backed securities for which the principal and interest payments are guaranteed by any of the government sponsored Agencies. This large concentration of adjustable rate securities in the company’s asset portfolio gives Capstead Mortgage the advantage of recovering financing spreads diminished during periods of rising interest rates; it allows for only smaller fluctuations in the portfolio value from changes in interest rates compared to portfolios with a concentration in fixed rate securities. The following chart displays the concentration of each type of MBS in CMO’s holdings. Fixed rate securities are the only negligible part of the company’s fourth quarter holdings.
Asset yields, cost of funds and interest rate spread
Yields on the company’s interest yielding assets averaged 1.76%, down 10 basis points compared to the linked quarter. Low interest rate environment and higher premium amortization costs were blamed to be the reason for such deterioration of asset yield during the fourth quarter of the prior year. Ultra low interest rates resulted in lower weighted average coupons for the company’s asset holdings as ARMs reset to the prevailing rates. The company seems to have not advantaged from the low interest rate environment. The cost of funds averaged at 0.63% during the fourth quarter, up 7% basis points from the linked quarter. The rise in costs was associated to higher market rates for repurchase agreements, which Capstead uses to finance its interest yielding assets.
Therefore, the interest rate spread or margin for the fourth quarter of the prior year averaged 1.13%, down 17 basis points from the spread earned during the linked quarter. The company experienced a 20 basis points decline in the third quarter’s interest spread. Therefore, the decline in spread has slowed down. This coupled with a rise in mortgage rates since the beginning of the year present investors with an ideal investment opportunity for the coming quarter.
Interest income, interest expense and earnings
During the fourth quarter, interest income of $61.16 million declined 4.5% from a year ago. Much of the decline in interest income was due to the aforementioned decline in asset yields, partially offset by a 13% surge in interest yielding residential mortgage investments. Interest expense of $22.9 million surged 29% year over year. Operating expenses of $3.28 million declined 24% over the same time period. Much of the decline in operating expenses was a result of a decline in incentive compensation. This resulted in a bottom line of $35 million, down 16.5% year over year.
At the end of the fourth quarter, Capstead reported a conditional prepayment rate (CPR) of 19.6%, compared to 18.7% during the linked quarter. The company’s leverage remained flat during the fourth quarter as it reported 8 times leverage at the end of the quarter.
The company’s closest competitors will include mortgage REITs that have a large concentration in Agency adjustable rate securities. Over a third of MBS holdings of CYS Investments (NYSE: CYS) are adjustable rate mortgages. I believe, CYS Investments will report results with similar trends. However, due to a diverse MBS portfolio, I believe the compression in spreads and acceleration in prepayment will be less compared to that of Capstead Mortgage. In contrast, Annaly Capital (NYSE: NLY), America's largest debt REIT, invests exclusively in fixed rate Agency MBS. However, recently the company has shown tremendous interest in diversification into commercial mortgage backed securities. Since Annaly Capital has a large concentration of fixed rate securities, it will experience much more acceleration in its prepayments, compared to both CYS and Capstead. These accelerated prepayments will hurt its bottom line in the fourth quarter.
The lower than expected performance of Capstead could be blamed to the ultra low interest rate environment and higher prepayments. Investors who have invested in or are looking to invest in Annaly Capital and CYS Investments should read the report as similar trends could be predicted in their fourth quarter performance. I believe, the trends have started to reverse and better performances can be expected during the first quarter of the current year.
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