It has been three years since Fed Chairman Ben Bernanke mentioned plans to reduce quantitative easing, sending markets into a fear induced “taper tantrum.” Analysts and investors were certain that we would soon find ourselves in a more normalized interest rate environment, bringing an end to a three-decade long stretch of decreasing interest rates.
But predicting such things is never easy. Investors who acted out of fear created opportunities to capture significant yield in assets that were punished in the months following Ben’s announcement. Some of those assets have yet to fully recover.
One such opportunity that we have uncovered is in the preferred shares of mortgage REIT
We like the REIT’s common stock but we’re particularly attracted to Hatteras’ 7.625% Series A preferred shares (NYSE:HTS-A). HTS-A is a cumulative and perpetual preferred stock with a $288 million total par value. Par value is $25 per share and the annual dividend is $1.90625, paid quarterly. HTS-A is currently trading at $24.10 per share and generates an attractive 8.0% yield. HTS-A is perpetual, meaning it does not have a maturity. HTS-A is callable at $25 in August 2017, however, we are purchasing the security under the assumption that it will not get called and that we will clip the 8.0% in perpetuity or until we decide to sell. Should HTS-A get called, the return would be greater than 8.0%, since it trades at a $0.90 discount to par.
For the trailing twelve months ending March 31st, HTS earned $225 million of net interest income and had $32 million of operating expenses, which generated $193 million of core earnings (excluding one-time gains and losses). As a result, HTS has $193 million of ongoing earnings to pay $22 million in preferred dividends - a very high coverage ratio of nine times. Additionally, HTS cannot pay any dividends to the common shareholders until HTS-A has been paid its preferred dividend. Since HTS is a REIT that currently pays 11.1% to its common shareholders, we realize that shutting off the common dividend would be extremely detrimental to the common stock. That being said, common shareholders would need to be virtually wiped out before there would be any permanent impairment to the preferred stock.
We are very comfortable with the credit of HTS-A given its U.S. Agency mortgage portfolio and floating rate concentration, which substantially reduces the risks associated with a levered financial entity. The most meaningful risk to HTS-A is its 11-year duration. Holding everything else constant, its price would decline by 11% for a 100 basis point instantaneous increase in interest rates; however, this is a mathematical duration and there may be a 'cushioning effect' should rates move higher.
We think that the duration will behave as if it were shorter than 11 years. Why? A price reduction, like the one mentioned above, would result in an elevated yield of 9.0%, which is extremely high for attractive credit in what would be a 3.2% 10-year Treasury environment. We also believe that over the next few years, we can earn a meaningful total return in excess of cash, despite potentially higher interest rates. After all, it helps when you start with an 8% advantage from the dividend.