MFA Financial Baby Bonds: A High-Yield Bet On The Mortgage Market

Main Thesis

In this article we will take a look at MFA Financial’s (MFA) 2042 Senior Note (MFO). With historically good interest coverage, a modest use of leverage, and a high-yield mortgage-backed securities portfolio, the Mortgage REIT has performed well financially. However, because of their alternative mortgage investments, they are exposed to quite a bit of credit risk. With chatter of another real estate bubble and falling prices, the baby bond is no sure thing.

Investing For Income – Time to Lock Up That High Yield?

Although MFO is a long duration security that can be subject to price swings due to changing interest rates and macroeconomic conditions, the current annual yield of 7.76% should afford debt investors patience. Furthermore, the debt issue is a senior unsecured note that takes priority over junior debt in the event of liquidation.

It should be noted, however, that the notes are currently trading at a premium to par. Being callable at any time, investors would lose money on this position if that were to occur.

(Source: NYSE)

Looking back at historical performance, there have been limited opportunities to pick up shares at or below par. With that in mind, if the firm’s credit profile fits your risk tolerance and would like to wait, there is a distinct possibility that the shares will not fall into a “buy range” before they are called away.

Corporate Strategy

(Source: MFA Q3 10Q)

As a player in the Mortgage REIT industry, MFA has a diversified portfolio of mortgage products to generate interest income. According to the company’s latest balance sheet, MFA’s current strategy is unique in the mREIT sector in that the majority of their holdings are non-agency residential MBS that are credit sensitive. Compared to agency MBS that are guaranteed by the U.S. government and pose interest rate sensitivity, this seems to be a wise choice. Given the climate of rising short-term rates and the flat yield curve, MFA’ strategy will pay off if their investments maintain credit quality throughout the business cycle.

Portfolio Interest Rate Sensitivity

(Source: Latest Investor Presentation)

In spite of a challenging interest rate environment for the Mortgage REIT industry, MFA management has done their job in delivering top-line yields that have kept pace with rising borrowing costs. They have done this effectively by allocating assets to interest rate swaps and lowering their portfolio’s duration or interest rate sensitivity. Furthermore, with fixed rate financing and a Adjustable Rate Mortgage (ARM) loan portfolio, they have not been materially affected by tightening monetary policy.

Portfolio Credit Risk

(Source: Latest Investor Presentation)

Although there are no excessive risks that are taken in their loans, there is no escaping the fact that MFA’s strategy is aggressive. As you can see from the statistics and facts above, they’re looking to alternative mortgage assets to generate a high yield. For example, although they do have reasonably high weighted average Loan to Value (LTV) ratios that require borrowers to have more skin in the game, the variable rate loans do present default risk if the payments become too expensive.

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Considering that they have targeted fix and flip investors and homeowners that don’t qualify for conventional financing, sustainability becomes a question mark now that real estate prices have begun to fall. Here in my native Los Angeles, we have certainly felt the pinch of rising housing prices so it remains to be seen whether the price cuts will continue.

Sustainability Analysis

(Source: Original Image – Data from latest annual report and latest quarterly report)

While MFA does take on material credit risk in their MBS portfolio, their strategy has paid off to deliver financial performance for shareholders and debt investors. An analysis of their financial statements indicates that the company is financially stable enough to comfortably service their debt. With a consistently positive book value, modest use of leverage, and a reasonable margin of interest safety, the baby bonds seem to be a safe bet to be serviced. However, it should be reiterated that their success is largely dependent upon the health of the mortgage market and macroeconomic conditions can adversely affect them if we experience a recession in the next few quarters.

Conclusion

All things considered, aggressive income investors should consider MFO for the high quarterly interest payments. Despite the historically strong financial performance, MFA’s underlying MBS portfolio is invested in largely alternative mortgage assets that are largely exposed to credit risk. Having hedged interest rate sensitivity, MFA’s financial performance really depends on the health of the mortgage market and the U.S. staying out of a recession.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.