MORL Dividend At 22.8% As Interest Rates Remain Low

On a year-to-date basis, the UBS ETRACS Monthly Pay 2X Leveraged Mortgage REIT ETN (NYSEARCA: MORL) has returned 33.9% based on a purchase at the end of 2015 at $13.28, the August 19, 2016 price of $15.50 and the dividends of $2.2819 paid this year through to August 2016. This does not include any reinvestment of dividends or any gains or losses on the reinvestment of dividends. On a one-year holding period MORL has returned 13.3% based on a purchase on August 19,2015 at $16.49, the August 19, 2016, price of $15.50 and the dividends of $3.1807 paid for the one year through to August 2016.

My projection for the September 2016 dividend for MORL and its’ essentially identical twin the UBS ETRACS Monthly Pay 2X Leveraged Mortgage REIT ETN Series B (NYSEARCA:MRRL) is $0.0346. The projection for the dividend is calculated using the contribution by component method. The Market Vectors Mortgage REIT Income ETF (NYSEARCA:MORT) is a fund that is based on the same index as MORL and MRRL. However, MORT is a fund rather than a note and thus does not employ the 2X leverage that MORL and MRRL do. MORT also pays dividends quarterly rather than monthly.

Even though MORL has increased in price, I am still a buyer. Mostly for the high dividend yield. Most of the MORL components pay dividends quarterly. Only two of the MORL components: American Capital Agency Corp. (NASDAQ: AGNC) and ARMOUR Residential REIT, Inc. (NYSE: ARR) pay dividends monthly. AGNC has reduced its’ monthly dividend from $0.20 to $0.18. The January, April, October and July “big month” MORL dividends are much larger than the “small month” dividends paid in the other months since most of the portfolio components pay quarterly, typically with ex-dates in the last month of the quarter and payment dates in the first month of the next quarter. Only AGNC and ARR will contribute to the September 2016 dividend, as is shown in the table below.

The year-to-date total return on MORL of 33.9% is what could have been expected given that there have been no rate increases by the Federal Reserve in 2016. In January 2016, even those most bearish on MORL and the mREITs would have conceded that if there were no rate increases by the Federal Reserve this far into 2016, then MORL would have had a high total return at this point in time. Obviously, those who were bearish on MORL at the beginning of 2016 were expecting multiple interest rate increases by now.

Even some Federal Reserve officials seem to be coming around to the view that the new normal may be lower rates for longer. Generally, Janet Yellen and other Federal Reserve officials do not talk about raising rates, but rather use the term normalization of interest rates. My view is that normal interest rates are not appropriate when you have very abnormal economic conditions.

Those calling for a normalization suggest that interest rates should be returned to somewhere near the averages that prevailed since the end of World War II. However, there has been a fundamental change world-wide this century that suggests that the rates that prevailed in the second half of the last century should not be considered as normal for the current period.

The primary change that has fundamentally changed the economy can be best described by Warren Buffett, CEO of Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B), who said, “Through the tax code, there has been class warfare waged, and my class has won,” to Business Wire CEO Cathy Baron Tamraz at a luncheon in honor of the company’s 50th anniversary. “It’s been a rout.”

One does not have to be a Keynesian to see that shifts in income to those with lower marginal propensities to consume will cause an increase in savings and a decline in consumer spending. The wealthy clearly have lower marginal propensities to consume. As I explained in a Unique Finance article “A Depression With Benefits: The Macro Case For mREITs”:

… In free-market capitalism, capital generates income for the owners of the capital, which in turn is used to create additional capital. This is very good. Sometimes, it can be actually too good. As capital continues to accumulate, its owners find it more and more difficult to deploy it efficiently. The business sector generally must interact with the household sector by selling goods and services or lending to them. When capital accumulates too rapidly, the productive capacity of the business sector can outpace the ability of the household sector to absorb the increasing production.
The capitalists, or if you prefer, job creators use their increasing wealth and income to reinvest, thus increasing the productive capacity of the business they own. They also lend their accumulated wealth to other businesses as well as other entities after they have exhausted opportunities within the business they own. As they seek to deploy ever more capital, excess factories, housing and shopping centers are built and more and more dubious loans are made. This is overinvestment…

Shifting income to the rich by taxing dividends, capital gains, inheritances and corporate profits much less than the tax rates on wages also tends to make more funds available for investment since when the investment is taxed relatively less, more funds are made available for the investment. That would also put downward pressure on interest rates.

The forces driving inequality through the class warfare that Warren Buffet points to are cumulative. It is the compounding effect of shift away from taxes on capital income such as dividends, capital gains and inheritances each year as the rich get proverbially richer which is the prime generator of inequality.

This cumulative shift of wealth from the middle class to the very wealthy has profound impacts on the economy and securities markets. It creates a cycle where initially the wealthy pour significant amounts into investments they perceive to be safe. This can first cause an increase in economic activity. In 2005 many considered mortgage-backed securities with adjustable interest rates to be essentially risk-free. This was especially true for those rated AAA by Moody’s and S&P. This resulted in overinvestment in the real estate sector. The middle class eventually could not service the mortgage debt on their homes nor could they buy enough goods at shopping centers and department stores to generate enough funds to prevent many residential and commercial mortgages from defaulting.

Overinvestment causing first a boom and then a bust is not new phenomenon. It is not just a coincidence that tax cuts for the rich have preceded both the 1929 depression and 2008 crisis. The Revenue acts of 1926 and 1928 worked exactly as the Republican Congresses that pushed them through promised. The dramatic reductions in taxes on the upper income brackets and estates of the wealthy did indeed result in increases in savings and investment. However, overinvestment (by 1929 there were over 600 automobile manufacturing companies in the USA) caused the depression that made the rich, and most everyone else, ultimately much poorer.

There does not seem to be any prospect for any reversal in the dismal fortunes of the middle class in what Warren Buffett describes as class warfare. When Obama was inaugurated in 2009, the Democrats had 60 out of 100 senate seats. However, what Warren Buffett describes as the winning class had 40 Republican senators and at least 12 Democrat senators. Thus, there was no diminution of the ongoing rout in the class war. Later, Obama was able to slightly increase taxes on the wealthy due to quirk whereby the Bush tax cuts were scheduled to expire. In order to give lip service to concern over the Federal deficit the Bush tax cuts had an expiration date when they were enacted. This gave Obama the leverage of being able to blame the Republicans for the tax increases on those with less than $250,000 in income, if they did not approve some rollback of the Bush tax cuts for the wealthy. It is unlikely that the winning side in the class warfare will make such a mistake again, as all future additional tax cuts for the rich such as elimination of estate taxes are likely to be permanent.

Even if it was widely understood that the shift of the tax burden from the rich to the middle class was the cause of the our economic problems, it would still be extremely difficult to remedy the situation. The enormous shift in tax policy favoring the rich has been a world-wide phenomena going on for many years. After the Socialist party candidate François Hollande won the presidential election, France enacted tax laws that gave France the most progressive tax system among the 20 largest industrial nations. However, the world-wide the tax systems have become so much less progressive in the past decades, that if the tax code that France has today were applied to France in 1969, France would have had the most regressive tax system among the 20 countries in 1969.

The question for MORL investors is how much of the class warfare paradigm does the central bankers of the world understand. In particular do they see the relationship between the class warfare and weak economies? The central bankers seem to be aware that today’s situation is not normal. The negative interest rates in many countries engineered by central banks is evidence of that. The Federal Reserve has not resorted to negative rates and actually raised short-term rates by 25 basis points in December 2015.

The December 2015 rate increase caused a dramatic decline in financial markets that resulted in a great buying opportunity in, among many other securities, MORL that closed at $9.22 on January 21, 2016. The question for MORL investors is will the Federal Reserve cause a repeat of the December 2015 debacle or have they learned their lesson?

The economy is growing at a very modest rate around 2% and inflation is still well contained. This modest growth has only been possible because of the Federal Reserve’s low interest policy. There are surely some households and businesses that are barely hanging on by their fingernails. They would possibly be unable to meet their financial obligations if the interest rates on their adjustable rate loans were increased by another 25 basis points.

Despite the risk to the economy that higher rates would entail, there are members of the Federal Reserve Open Market Committee who seem to favor rate increases. There are some legitimate concerns related to the low interest rate policy. Investment behavior is impacted by the low interest rate policy in ways that could be problematic.

It may be difficult to separate the impacts on investor behavior due to the shift of the tax burden from the rich to the middle class and that due to the low interest rate policy. In some cases they are intertwined. The winners in the class warfare are being increasingly pushed into intra-class investments as opposed to inter-class investments. An intra-class investment would be buying a $40 million apartment in Manhattan or a Picasso painting. The problem with buying intra-class investments that benefit from to the shift of the tax burden from the rich to the middle class is that they are relatively illiquid. Shares of blue-chip companies such as McDonalds (NYSE:MCD) or Walmart are very liquid. However, the shift of the tax burden from the rich to the middle class can reduce sales and income for companies that do not cater to the rich. Many have suggested that shifting investments to relative sterile investments such as existing assets like old master paintings, ultra-luxury real estate and jewels as opposed to shares in publicly held corporations is detrimental to economic growth. Most publicly held corporations depend either directly or indirectly on sales to the non-rich.

It is not that clear the effect that very low interest rates have on the share of investments allocated to intra-class investments as opposed to inter-class investments. It is much clearer that very low interest rates have increased carry-trade types of investments where investors borrow money at low short-term rates and benefit from the spread between long and short rates. That is exactly what investors in MORL such as me and probably many of the readers of this article are doing.

An apt analogy to the decision facing the Federal Reserve would be that of someone taking a life saving drug with some of the side effects you hear listed in the television commercials for most drugs. Low interest rates are a drug that is keeping the patient alive, but there is a danger that the side effects of the drug may be very serious.

A complicating factor is that it is possible that the low interest rates are not necessarily due to Federal Reserve policy but rather from the imbalance is the supply and demand for loanable funds that results from the winners in the class warfare having much more funds to invest and lend. The laws of supply and demand apply differently to the market for loanable funds as compared to commodities. With commodities, equilibrium reached when the quantity supplied is equal to the quantity demanded. The debt or loanable funds market is more complex. A simple example illustrates this. An increase in government deficits accompanied by a commensurate increase in the issuance of government debt would normally be thought of as causing an increase in interest rates. However, the cause and/or purpose of the government deficits have a tremendous impact in terms of how interest rates are affected.

A government deficit for the purpose of funding a tax cut for those with high propensity to save has a much different impact on interest rates than the deficit of a similar magnitude whose purpose is to fund an increase in social or defense spending. When the Federal government sells bonds and uses the proceeds to cut taxes on the wealthy, which in turn now has more money to lend, the net effect is to push down interest rates. This is especially true when the central banks are the buyers of much of the government debt.

As long as there is a much greater supply of loanable funds than the demand for them in the risk-free credit market, risk-free and near-risk-free interest rates should remain low. Attempts by the Federal Reserve to push risk-free rates higher than what supply and demand would otherwise indicate might only result in weaker economic activity. Lower rates are by far the best environment for UBS ETRACS Monthly Pay 2xLeveraged ETNs such as MORL and MRRL.

One could argue that my view on interest rates has prevailed for the last three years and mREITs have declined in price over much of that period. Some of the decline is due to actions taken by some of the mREITs’ managers, which have been inept or worse. However, most mREITs have gone from trading at premium to book value to deep discounts to book value. While there are risks and problems associated with mREITs and MORL, it is the enormous yields, which I think will ultimately result in mREITs and MORL providing substantial returns as long as interest rates remain subdued.

Even though MORL has increased in price, I am still positive on it. Mostly for the high dividend yield. The table also shows the price, ex-date, dividend, dividend frequency and contribution to the dividend for the two components that will contribute to the September 2016 dividend.

The increase in MORL’s net asset or indicative value has also been a factor in maintaining the high dividend. The 2X leverage requires a rebalancing each month to maintain the equivalent of 50% equity and 50% borrowing in the dividend and value calculations. This means that effectively the number of shares in each component that each share of MORL represents is increased when the indicative value rises and is reduced when the indicative value declines. Thus, even if every mREIT in the index kept its dividend unchanged, an increase in MORL’s indicative value would cause an increase in MORL’s monthly dividend. The relationship between the net asset value of a 2X leveraged ETN and the dividend is explained more fully in ” MORL’s Net Asset Value Rises – Implications For The Dividends.”

Even after the rebound in MORL and MRRL from the January 2016 lows, the yields are still relatively large. For the three months ending September 2016, the total projected dividends are $0.8016. The annualized dividends would be $3.206. This is a 20.7% simple annualized yield with MORL priced at $15.50. On a monthly-compounded basis, the effective annualized yield is 22.8%.

Aside from the fact that with a yield around 20%, even without reinvesting or compounding you get back your initial investment in only five years and still have your original investment shares intact, if someone thought that over the next five years’ interest rates would remain relatively stable, and thus, MORL would continue to yield 22.8% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $278,855 in five years. More interestingly, for those investing for future income, the income from the initial $100,000 would increase from the $22,765 initial annual rate to $63,481 annually.

Holdings of MORL and MRRL Prices 8-19-2016, Weights 8-1-2016

Name	Ticker	Weight	Price	ex-div	dividend	frequency	contribution
Annaly Capital Management Inc	NLY	16.21
American Capital Agency Corp	AGNC	9.37	19.87	8/29/2016	0.18	m	0.0264
Starwood Property Trust Inc	STWD	6.99
Chimera Investment Corp	CIM	5.46
Two Harbors Investment Corp	TWO	5.15
Blackstone Mortgage Trust Inc	BXMT	5.09
New Residential Investment Corp	NRZ	4.94
MFA Financial Inc	MFA	4.7
CYS Investments Inc	CYS	4.65
Colony Financial Inc	CLNY	4.32
Pennymac Portgage Investment	PMT	3.84
Invesco Mortgage Capital Inc	IVR	3.77
Apollo Commercial Real Estat	ARI	3.03
Capstead Mortgage Corp	CMO	2.9
Hannon Armstrong Sustainable Infrastructure Capital Inc	HASI	2.67
ARMOUR Residential REIT Inc	ARR	2.66	22.04	8/11/2016	0.22	m	0.0082
New York Mortgage Trust Inc	NYMT	2.61
American Capital Mortgage Investment Corp	MTGE	1.94
Redwood Trust Inc	RWT	1.88
Istar Inc	STAR	1.75
Ladder Capital Corp	LADR	1.7
Anworth Mortgage Asset Corp	ANH	1.59
Western Asset Mortgage Capital Corp	WMC	1.51
Resource Capital Corp	RSO	1.23

Disclosure: I am/we are long MORL, MRRL, AGNC, ARR.

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