A look at mortgage closed-end funds

There are a handful professional investors that I follow closely to see what they think is attractive and what isn’t. Murray Stahl’s (FRMO CEO) letters to shareholders are always an interesting read, and so are the (semi-) annual reports of the Special Opportunities Fund that is run by Philip Goldstein. Both were released recently, and as you could have guessed based on the title of this post both like mortgage closed-end funds.

From the FRMO 2013 letter to shareholders:

Recently, fixed income as an investment has become questionable, given increases in interest rates. We have no views as to the likely direction of monetary policy. Yet, the closed-end fund market is one of the least efficiently priced areas of securities markets. It is frequently possible to purchase funds at not insubstantial discounts to net asset value that are managed by genuinely talented individuals. In other words, we can buy the same bonds that they buy except, in our case, they are cheaper since we take advantage of the discount. Most recently, it has become possible to purchase mortgage funds at discounts to net asset value. These funds hold mortgages of 2005 vintage with high loan to value ratios, since that was accepted practice in 2005. However, the mortgages are current and there is a strong incentive against default because of the self-amortizing nature of a mortgage when existing for 8-9 years. The mortgages trade at discounts to par. The funds yield between 8-9% with yields to maturity of meaningfully higher levels. Our investments are not very substantial. However, that is the general direction of our fixed income investing.

When you read this it certainly sounds like an attractive investment, and since the number of closed-end funds invested in mortgages isn’t high it isn’t hard to figure out the funds in question (more about that later). First lets take a look what Philip Goldstein is doing:

BSP and CSP are sister closed-end funds sub-managed by Nuveen. Each fund invests a substantial percentage of its assets in whole mortgage loans and to a lesser extent, in U.S. Government securities, corporate debt securities, preferred stock issued by real estate investment trusts, and mortgage servicing rights. Both funds’shares have long traded at a double digit discount to NAV. We have had discussions with management about the need to provide an exit for shareholders of CSP, our older position, at or close to NAV, but nothing definitive has resulted thus far. As a result, on July 10th, we formally submitted a proposal recommending that CSP’s shareholders be afforded an opportunity to realize a price at close to NAV for their shares. If the board does not respond favorably, we intend to seek representation on the board via a proxy contest. BSP is a new reporting position for us. We filed our initial Form 13D on July 26th. BSP is similarly in need of a liquidity event and we intend to pursue a similar strategy to achieve that.

Reading this description it’s clear that Murray Stahl and Philip Goldstein aren’t invested in the same funds. BSP and CSP have been trading at a discount for years while the unnamed funds that Murray Stahl likes have only started trading at a discount recently.

The CEF mortgage space

The number of CEF’s that invest in mortgages is limited: there are just 13 different funds so it’s easy to get an overview of the entire sector. I have compiled an overview of the various funds in the table below:

Mortgage closed-end funds overviewBased on the description in the FRMO 2013 letter I think the funds that Murray Stahl likes are the two Nuveen Mortage Opportunity Term funds. They yield between 8 and 9 percent and have only recently started trading at a significant discount to NAV.

One thing that’s in my opinion very positive about the two Nuveen CEF’s is that they have a limited life: they are automatically dissolved 10 year after their creation. JLS was created at the end of 2009 while JMT was created in the beginning of 2010. If a manager doesn’t add any alpha a CEF deserves to trade at a discount to NAV because you will be paying fees perpetually, unless of course an activist investor like Philip Goldstein comes along and put the CEF out of it’s misery.

With JLS and JMT you know you will get back your investment at NAV, so when you buy at a discount near 10% you basically get professional management for free. Murray Stahl seems to think those fund are managed by genuinely talented individuals and that the underlying assets are very attractive. Unfortunately for me I don’t know a whole lot about mortgages, how attractive these assets are and the quality of the funds management.

The funds have obviously a pretty decent yield, but they also employ leverage (slightly above 25%) and I doubt that the yield is sustainable given the fact that they currently pay out a bit more than they earn.

What might also be an interesting opportunity is the American Strategic Income I fund. Philip Goldstein is already involved in the #2 and #3 funds, and the #1 fund has by far the biggest discount currently at almost 17%. I think it’s a safe bet that he has noticed this, and you might be able to buy before he announces a position (unless there is of course a good reason why this specific fund isn’t a good candidate for activism). Usually the discount already shrinks when an activist investor announces that he has taken a position in a CEF.

Conclusion

I like to buy things that are so obvious cheap that a monkey can understand the investment case. Unfortunately I don’t think this is true at the moment with JLS, JMT or ASP. They are not expensive, but a ~10% discount doesn’t scream value to me either. Maybe the underlying assets are indeed attractive, but I have no idea what I’m exactly buying when I look at the funds holdings… That’s too bad because I have to admit that I do like the idea of owning Mortgage Backed Securities simply because it’s an asset class that I don’t already have in my portfolio. Maybe I have a reader with more knowledge about the sector?

Disclosure

No positions at the time of publication in any of the mentioned funds.

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