MFA Financial (“MFA”) Series C fixed-to-floating rate cumulative redeemable preferred stock is an attractive short duration fixed income instrument that I expect to generate approximately a 25% IRR and 40% total return over the next year and a half.

The opportunity exists because 1.) the interest rate and mortgage spread environment over the last two years has presented a challenging backdrop for levered long fixed income investing strategies, 2.) one mortgage REIT peer took a surprising position with respect to the LIBOR transition, and 3.) preferred instruments broadly have been out of favor.

I believe the go forward environment for mortgage REITs is conducive to generating positive economic returns, PMT’s position with respect to LIBOR transition is the exception rather than the rule, and there are early signs of increased investor demand for preferred instruments.

MFA Series C preferred will begin paying quarterly dividends at an annual rate of 5.345% over 3-month term SOFR as of March 31, 2025. Mortgage REIT fixed-to-floating rate preferreds that have already reset to floating rate such as AGNC Series C (+5.111%), Annaly Series F (+4.993%) and Annaly Series G (+4.172%) trade at or near par (98% to 101% of par).

Assuming MFA Series C preferred trades at 95% of par once the first floating rate dividend is paid in June 2025, this preferred will generate an approximate 25% IRR and 40% total return. Assuming MFA Series C preferred trades at par once the first floating rate dividend is paid, this preferred would generate a 29% IRR and 48% total return.

Company overview

MFA is a mortgage REIT that invests primarily in residential mortgage assets. The company funds itself via both the repo market as well as the securitization market. Total leverage is approximately 4.5x debt to equity and recourse leverage was 2.0x as of the most recent quarter.

Source: MFA investor presentation

The company has generated a middling economic return year to date and is modestly outearning its dividend. At September 30^th, MFA had $475 million in liquidation value of preferred relative to $1.4 billion in book value of common equity. This ratio puts MFA in the middle of the pack relative to its peers.

Importantly for the preferred, MFA has indicated no desire to increase its common dividend and also no desire to repurchase stock.

Mortgage spreads are at attractive levels

Source: Convexity Maven

AGNC on 10/31/2023: “Our outlook for Agency MBS is very favorable. Spreads have decoupled from treasuries and corporates due to supply and demand technical factors that we expect will ease over time…spreads and other fixed income sectors are close to post-GFC long-term averages, which spreads on Agency MBS are in the 95-plus percentile area.”

MFA on 11/7/2023: “Mortgage spreads are indeed very wide today, but they were at similar levels in 1986, and ’87, in 1999 and 2000 and in 2008 before the Fed began its first round of QE.”

The PMT LIBOR transition wrinkle

PennyMac Mortgage Investment Trust (“PMT”) is a mortgage REIT with two series of fixed-to-floating rate preferred stock. On August 25, 2023, PMT issued a press release stating their position that the Federal Reserve’s LIBOR rule would result in PMT’s fixed-to-floating rate preferred not transitioning to a floating reference rate as a result of USD LIBOR being phased out.

PMT’s press release can be found here.

I believe PMT has taken an aggressive and unique position and am not aware of any other company that has or has indicated an intent to take a similar position. I believe that MFA’s Series C preferred will transition to floating, as scheduled, with the floating benchmark referring to Term SOFR rather than LIBOR for the following reasons:

1. Large banks with a significant number and amount of floating rate debt and preferred instruments have transitioned from LIBOR to Term SOFR. Here are announcements from JPMorgan, Citi and Goldman for reference.
2. Mortgage REITs that have currently floating preferreds have transitioned from LIBOR to Term SOFR. Here are the most recent preferred stock dividend announcements from AGNC and Annaly referencing the new floating benchmark rate.
3. Several Mortgage REITs with fixed-to-floating rate preferred have publicly filed or stated their intentions to transition to Term SOFR. Here is a footnote from Two Harbor’s most recent 10-Q stating such.
4. MFA management has indicated to investors that the Series C preferred floating benchmark will be Term SOFR when it floats.
5. Perhaps most importantly, the MFA Series C preferred indenture has language that differs materially from and is better than the language in PMT’s preferred documents in that it provides for a “Calculation Agent” to make a benchmark determination in the event the polling provision fails. The PMT preferred documents do not incorporate the concept of a Calculation Agent.

Preferred stocks have been under pressure

Below is a chart showing fund flows for the largest preferred ETF, iShares Preferred and Income Securities ETF (Ticker: PFF). Flows have been broadly negative in the recent period against a backdrop of rising interest rates and stress in the financial sector, which is the largest issuer of preferred securities. Since the beginning of November, PFF has had the largest 3-week period of inflows over the last two years. A continuation of this trend could provide a favorable tailwind for this investment. PFF holds MFA Series C preferred stock.

Source: www.etf.com

Comparables

Below is a selection of fixed-to-floating rate preferreds issued by mortgage REITs with relatively near term reset dates. The MFA Series C preferred trades at the bottom end of the valuation range based on a variety of metrics despite the company generating middle of the pack investment performance and having a middle of the pack capital structure.