MVRL And The MREITs After The Federal Reserve Initiates Rate Hikes (NYSEARCA:MVRL)

Market Reactions to Recent Events Have Been Relatively Muted

The financial markets’ reaction to first interest rate hike by the Federal Reserve has been fairly muted. It could be a case of “buy on the rumor and sell on the news” or the financial markets may be perceiving or have knowledge of things not now apparent. The reaction of the financial markets to the rate hike and more importantly, to the surge in inflation, so far is much different than some previous episodes.

In February 2022, the year-over-year CPI reached 7.9%. The investment community’s response to this level of inflation could be summed up as: “investors might want to consider lowering their weighting of longer duration fixed income assets.” In contrast, when in August 1978 the year-over-year CPI reached 7.9%, the investment community’s response to that same level of inflation then could be epitomized as: “bonds are certificates of confiscation” sell them now!. The bond market sell-off that ensued as the year-over-year CPI rose and peaked at 14.6% in April 1980, eventually pushed the yield on the 10-year treasury to above 15%.

The reaction of the equity markets in response to the invasion of Ukraine and all of the threats that it implies, has also been muted as compared the reaction to Covid-19 in March 2020. The invasion of Ukraine poses severe risks to the supplies of key commodities, including but not limited to: oil, gas, fertilizer, nickel, aluminum and neon. Ukraine is a major producer of neon gas, critical for lasers used in chipmaking and supplies more than 90% of U.S. semiconductor-grade neon.

One possible explanation for the markets’ relative strength in the face of the possibility of World War III and the other supply and trade disruptions, is that it appears that the “good guys” may be winning, or at least not being rolled-over by the Russian forces, as many believed would be the case. A major stock market bottom occurred in June 1942 on the day before the massive American victory in the Battle of Midway. After that battle, which was considered a turning point in the war, stocks never saw the levels of the early June 1942 lows again.

The Threat to the mREITs of Higher Interest Rates

Many market observers, including some Federal Reserve officials, are looking for as many as nine rate hikes. Additionally, most market participants expect the Federal Reserve to not only halt their purchases of treasuries and agency mortgage-backed securities, but that the Federal Reserve will then start to reduce the size of their balance sheet by selling some of their treasuries and agency mortgage-backed securities.

The mREIT market has not ignored the raising interest rates environment. Higher short-term interest rates are unambiguously bad for entities that rely on leverage by financing long-term securities with short-term borrowing, such as mREITs. It is even worse for leveraged ETNs, which add an additional layer of leverage. The only leveraged mREIT ETN remaining is ETRACS Monthly Pay 1.5X Leveraged Mortgage REIT ETN (NYSEARCA:MVRL). The behavior of MVRL, which is based on the MVIS US Mortgage REITs Index, illustrates what has happened to the mREITs. Since June 2021 when MVRL traded at a high $52.90, it has fallen to a low of $32.35 and closed on March 25, 2022 at $38.48. At that price the current yield is 15.25%. That figure is based on the yield calculation methodology shown on the UBS website.

…Current Yield (annualized)” equals the sum of the most recently announced Coupon Amount and the two immediately preceding Coupon Amounts, multiplied by four (to annualize such coupons), divided by the Current Indicative Value of the ETN…

That methodology does not take into account monthly compounding. Since MVRL pays dividends monthly, a more accurate measure of what the return would be if the price and dividends remained constant, would be 16.4%, which accounts for monthly compounding annualized.

As was discussed in MVRL And The mREITs Are Now A Contrarian Play, there are many risks on the horizon. These include the possibility of a new COVID-19 variant, the war in Ukraine spinning out of control and its implications for possible defaults worldwide. These are real threats. However, some of those prospective risks could tend to make the total Federal Reserve tightening less severe. My view is that any market declines resulting from those events could be viewed as a buying opportunity for the mREITs and MVRL.

My view is primarily based on my original premise for investing in mREITs and later leveraged mREIT ETNs, as described in my 2013 Seeking Alpha article, A Depression With Benefits: The Macro Case For mREITs. The key factor is the tremendous shift in the tax burden away from the wealthy, who have a high propensity to save and invest, and on to the middle class, which have a higher propensity to spend and borrow. That tax policy has resulted in a glut of funds looking for places to deploy those funds. This has supported securities prices and kept interest rates low.

The years 2020 and 2021 saw a reversal of the tax policy environment favoring the rich, as most pandemic-related payments to low and middle-income individuals from the Federal Government took the form of refundable tax credits and rebates. This was described in REML: Is The 15% Current Yield Worth The Unique Risks?

It appears that tax policy ongoing will now revert back to what Warren Buffett, CEO of Berkshire Hathaway (BRK.A) (BRK.B), was describing when he said that:

“… through the tax code, there has been class warfare waged, and my class has won. It’s been a rout…”

There does not appear to be much likelihood that the Administration’s “Build Back Better Bill” which included continuation of the refundable tax credits for most families with children will be enacted any time soon. Most prognosticators see the Republicans winning one or both chambers in the 2022 elections. That would seem to remove the possibility that the Federal income tax could become as progressive as it temporarily became due to the pandemic-related refundable tax credits and rebates. However, the outcomes of the 2022 elections are far from certain.

The Democrats could make the 2022 elections referendums on the $300/per child/per refundable month tax credits that gave tens of millions of parents checks. The Democrats could, for example, pass a stand-alone bill that restores the checks and pays for it by raising corporate income taxes. Any Republican in a district that Trump won by less than 10% can either vote for that or lose their senate or house seat in 2022.

The reason I think that the Democrats could possibly pull an upset in 2022 is that they might learn from what happened in the 2020 Georgia senate races. In November 2020 the two incumbent Republican senators in Georgia had clearly won the election, with only the formality of the runoff to ensure Republican control of the senate. The only reason that the incumbent Republican senators did not get the 50% of the vote required to avoid the runoffs, was that more conservative minor candidates had received some of the votes in the November 2020 election, which forced runoffs between the top two contenders.

In the period leading up to the Georgia Senate runoff elections, Trump demanded that the $600 payments to most individuals included in pending Covid-19 relief legislation be increased to $2,000. The House of Representatives eagerly embraced this increase. However, McConnell refused to allow the House-passed bill with increase to $2,000 to be voted on in the Senate. This created a situation where the incumbent Republican Georgia Senators and their challengers all expressed support for the higher payments. However, only if the Democrats won both Senate races would control of Senate change, because by the Senate rules, the newly elected vice-president could then vote to break the 50-50 tie, would a bill with the higher payments to individuals actually be enacted. In the runoff voters voted on whether or not they would get the extra $2,000. That was an easy vote for many.

The tax policy that has resulted in a glut of funds looking for places to deploy those funds, is the reason that I have been asserting that short-term interest rates would be even lower or negative, but for efforts by the Federal Reserve to keep them up. See: Federal Reserve Actually Propping Up Interest Rates: What This Means For mREITs

Today, as of March 25, 2022 the Federal Reserve is maintaining $1.68 trillion in its reverse repo facility in order to prevent short-term risk-free interest rates from going negative. Even with the current high level of inflation, the recent increase in the target Federal funds rate by the Federal Reserve, would still leave most non-bank institutional investors seeking short-term risk-free investments, forced to accept investments with negative interest rates, if they did not have the ability, that they have now, to park cash at 30 basis points via the Federal Reserve’s reverse repo facility.

Analysis of the April 2022 MVRL Dividend Projection

The use of a three-month trailing sum of the dividends in computing the current yield for ETNs is very appropriate for the leveraged mREIT ETNs, since most of the MVRL components pay dividends quarterly, typically, with ex-dates in the last month of the quarter and payment dates in the first month of the next quarter. The rest of the component mREITs pay monthly dividends. This creates a situation where the January, April, October, and July “big month” MVRL dividends will be much larger than the “small month” dividends paid in the other months. This is because few of the quarterly payers have ex-dividend dates that contribute to the dividends in the “small months.” Thus, the April 2022 dividend will be a “large month” dividend.

After many increases in the dividends by some of the mREITs during the past year, there were three increases and one decrease, in the dividends paid by components of the MVIS index upon which MVRL is based, that will impact the April 2022 MVRL dividend. Arbor Realty Trust Inc. (ABR) increased its quarterly dividend to $0.37 as compared to the previous level of $0.36. Brightspire Capital Inc (BRSP) increased its quarterly dividend to $0.19 as compared to the previous level of $0.18. Orchid Island Capital Inc (ORC) decreased its monthly dividend to $0.045 as compared to the previous level of $0.055. Hannon Armstrong Sustainable Infrastructure Capital Inc (HASI) increased its quarterly dividend to $0.375 as compared to the previous level of $0.35. However, the HASI dividend has an ex-date of April 1, 2022. Thus, it will impact the May 2022 MVRL dividend.

The Table I below shows the ticker, name, weight, dividend and ex-date, for all of the components. Additionally, Table I includes the prices and contribution to the dividend for the MVRL components that will contribute to the April 2022 MVRL dividend.

My projection for the April MVRL dividend is $0.952. While typically called dividends, the monthly payments from MVRL and all securities-index-based ETNs, are technically coupons that are distributions of interest payments on the ETN note, based on the dividends paid by the underlying securities that comprise the index, pursuant to the terms of the indenture. Thus, when dealing with ETNs, the terms “dividend” “coupon” and “distribution” are often used interchangeably. Also, the terms “shares” and “notes” are used interchangeably with ETNs. Also used interchangeably with ETNs, are the words “net indicative value” and “net asset value”.

Conclusions and Recommendations

It is possible that current mREITs values are due to market participants having their heads in the sand regarding the extent of how much interest rates will rise. Conversely, the mREIT market participants may be taking into account the tremendous uncertainty regarding the future path of inflation and interest rates. There are many “black swan” possible events that could make the current surge in inflation actually be transitory.

The supply constraints from the lingering Covid-19 issues could be cleared up. Likewise, an early settlement of the war between Ukraine and Russia could end all of the supply problems resulting from the sanctions and destruction. As discussed in OILK: An Energy Crunch In The Making – Needlessly, the Biden Administration could very significantly reduce retail gasoline prices by suspending the requirement that: in order to sell a gallon of gasoline in the USA, one must purchase a renewable identification number (RIN). The obvious move would be to suspend the requirement through to November 2022.

Consumers do not buy crude oil, they buy gasoline. A massive decline in retail gasoline prices would impact both the consumer price index and the personal consumption deflator, which is the Federal Reserve’s preferred inflation measure. Even the ultimate result of the war in Ukraine in terms of energy prices is very uncertain. One scenario could be that the classic saying that “the cure for high prices is high prices” could work this time, as increases in conservation and relaxation of the various government policies that have restricted the supply of fossil fuels could result in lower fuel costs and thus lower inflation.

The consensus is that the Federal Reserve will attempt to fight inflation by continually raising interest rates in order to recruit “conscripts” in the war against inflation, otherwise known as unemployed people. One variable is the labor force participation rate. If the labor force participation rate were to return to its historic business cycle pattern, that could significantly increase the official unemployment rate. See: Covid, Disability and Labor Force Participation. That would certainly reduce the impetus for further Federal Reserve tightening.

One issue is that many think that inflation is primarily a monetary problem to be solved by monetary policy. By the early 1980s inflation was tamed, the year-over-year CPI had fallen to 2.4% by July 1983. Paul Volcker, Fed Chairman from 1979-1987 is usually given most of the credit for the reduction in inflation. However, Alfred Kahn, whose title was Chairman of the Council on Wage and Price Stability, but was referred to in the press as the “inflation czar,” possibly deserves more credit. Arguably, there are some prices today that are lower than they were 40 years ago because of Alfred Kahn. Airfares and trucking rates being examples.

When Alfred Kahn joined the Civil Aeronautics Board in 1977, its main function was to set minimum airfares and restrict competition in the airline industry. Airlines and trucking were regulated by the Federal Government. The industries and the unions used their political power to keep airfares and trucking rates far above what free-market prices would be. A large portion of the excessive prices ended up the workers’ wages. The airfares on interstate flights or truck routes were regulated. However, flights within a single state could not be regulated by the Federal government.

On a per mile basis interstate flights or truck routes were much higher than flights or truck routes within a single state. For example, the distance between New York City and Philadelphia is 81 miles. An intrastate flight from New York City to Buffalo, New York is 292 miles. The regulated airfare for a 81 mile flight from New York City to Philadelphia was about four times that of the unregulated airfare for the much longer flight New York City and Buffalo.

To ship a certain load of goods from New York City to Buffalo, New York, a road distance of 373 miles there was a certain free market rate. It costs more than double that rate to ship the same goods by truck from New York City to Philadelphia a distance of only 97 miles by road. Likewise, the cost to ship from Los Angeles to San Francisco a distance by road of 382 miles was less than half the cost of shipping the same goods from Los Angeles to Las Vegas only 266 miles. Airfare from Los Angeles to San Francisco, a distance by air of 347 miles was less than half that of the regulated Los Angeles to Las Vegas route of only 225 miles by air. In both cases, the difference between the non-regulated intra-state rates and the regulated interstate rate was solely due to the regulation of trucking rates by the Interstate Commerce Commission and airline fares by the Civil Aeronautics Board.

Another way to quantify the effect of regulation was to compare the trucking rates on raw produce such as live chickens or fresh tomatoes. If a farmer wanted to ship live chickens or fresh tomatoes a certain distance, there was a free market rate. If those same tomatoes or chickens were processed and put in cans and then shipped an identical distance as the farm to plant, the regulated rate was more than triple the price that the farmer would pay. This of course was because one group that had even more political power than the truckers and teamster unions, was the farmers. Thus, raw produce was exempt from the federal trucking rate regulation.

So far, we have not seen anyone like Alfred Kahn with the power and influence to reform government policies which cause inflation. I suspect that if Alfred Kahn was around today, he would be screaming about the Renewable Fuel Standard program administered by the U.S. Environmental Protection Agency. This program which started more than twenty years ago has nothing to do with climate change. Rather, its intent was to promote ethanol production, in order to reduce America’s dependence on imported oil. Fracking solved that problem. When the carbon released by the combustion and production of agriculturally derived ethanol is considered, it likely has no benefit in terms of climate change.

Absent anyone like Alfred Kahn policies to fight inflation will only be undertaken by the Federal Reserve. There are some possible contrarian reasons that could reduce the prospect of further rate hikes by the Federal Reserve. These could even include refugees from the conflict in the Ukraine and elsewhere, adding to labor supplies in the OECD countries including America. This could alleviate some of the pressure on wages.

Given all of the uncertainty I am still a cautious buyer of MVRL, especially on dips. The 16% yield compensates for many risks. One consideration discussed in: Leveraged mREIT ETNs Offer Very High Current Yields, is liquidity. MVRL only started trading on June 3, 2020. It has extremely low trading volume. The 90-day average volume for MVRL is 10,662 as of March 25, 2022, which is relatively low. However, the Median Bid/Ask Spread as a percentage of the trading price is actually better for MVRL than for many other securities. As of March 25, 2022, the median bid/ask spread (30 Day) for MVRL was only 0.36%. I think that UBS is supplying some liquidity to the MVRL market to keep the bid/ask spreads that low.

Table I MVRL Components and Contributions to the Dividend