Capstead: Time to Buy Mortgage REITs

07/14/2015 7:00 am EST

Focus: REITS

Briton Ryle

Editor, The Wealth Advisory

Our latest featured recommendation is a mortgage REIT, or mReit, which borrows money at one rate and then buys mortgage bonds that pay a higher rate, explains Briton Ryle, editor of The Wealth Advisory.

Capstead Mortgage Corp. (CMO) is small, with a market cap of just over $1 billion. It currently has a mortgage portfolio valued at $14 billion. CMO profits from the difference, or spread, between borrowing costs and interest rate income.

When the US economy started to show improvement in mid-2012, mREITs sold off on the expectation that interest rates would rise sooner than later.

Remember, when interest rates rise, the face value of bonds falls. For the mREITs, that can be disastrous, because if the face value of their bond portfolio falls, their leverage situation gets turned on its head.

We view the Fed’s statements as reassurance that rates are not going through the roof, mREITs and Capstead should be able to put in a nice rally. In my view, Capstead will benefit from a stable interest rate. And the improving housing market will help, too, as there will be more mortgages in circulation.

All mREITs use leverage to buy mortgage bonds. Capstead is leveraged 8.5 times, which is right at its average over the last decade.

Capstead focuses on short-duration ARM securities that are issued by the GSEs (government sponsored entities). This is a good strategy as Capstead can quickly realign its portfolio to accommodate interest rate changes.

In 2013, Capstead changed its dividend policy from a variable dividend to a stable, declared one. It currently offers a 10% dividend yield.

And finally, earnings estimates for Capstead have been rising. All of these things bode well for higher dividend payments for Capstead. I rate Capstead Mortgage a strong buy below $12.25 with a 12-month price target of $14.

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