How The Fed Is Creating An ‘Incredible Mispricing Of Risk’
Earlier this week I published a piece on the CFA Institute’s Inside Investing section titled: Mortgage REITs: Does Doubling the Leverage Make Them a Good Investment? The post was my response to UBS launching an ETN that provides 2x leverage on a basket of already heavily levered mortgage REITs “mREITs”.
In short, I believe it’s a dangerous product as many investors in the underlying REITs have little idea how 10%+ yields are being generated. Moreover, they don’t understand the scenarios that could lead to a significant decline in share prices. To paraphrase the great Howard Marks, “…do not confuse adding leverage to an existing investment with increasing return…if you take a 10% return in a security and lever it up 4x and after financing costs generate 15-20% returns, you haven’t increased your returns, you’ve just increased your leverage and significantly increased your risk, but you’ve also got a 20-25% downside threat”. I think this thinking certainly applies to mortgage REITs today.
A bigger threat is upon us
Last week Annaly Capital’s CEO Wellington Denahan-Norris (who this week replaced the late Michael Farrell who tragically passed away), said some very interesting comments to Bloomberg on the state of the risk markets. After discussing the impact of the Fed buying Agency MBS she said:
“It’s not just at the mortgage REITs where the returns in this market are being put under assault, It’s the general global landscape where you have an incredible mispricing of risk that’s being delivered at the hands of academics at the central banks of the world.”
I could not have said it better myself. I am firmly in the camp that both credit and duration is being dramatically mispriced due to the actions of the Fed. They’ve created a reckless chase for yield that is being driven not so much by greed, but rather by needs based investing. The yield piñata has burst and participants far and wide are scurrying to accumulate what they can across all sectors of the fixed income markets: IG corporates, CMBS, Non-Agency MBS, High Yield, Levered Loans, Munis, and others.
While equity focused investors don’t see the direct impacts of the Fed’s purchases, the spillover is pronounced in fixed income and is causing imbalances far and wide. When I read the article about UBS’ new 2x leverage mREIT product, I couldn’t help but think that we are starting to see signs of these policies backfiring as the chase for yield has reached a more than unhealthy level.