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Capstead Mortgage Corporation (NYSE:CMO) is overvalued. While I believe the preferred shares are a great bargain, the same cannot be said about the common stock. CMO trades extremely close to the lowest dividend yield on record and at a much higher-than-normal price-to-book ratio. While management is excellent, the team is facing macroeconomic problems. There is very little management can do to combat these problems. It isn't a matter of skill; it is a matter of the yield curve. As CMO faces these challenges, despite all the problems, the stock rallies back toward the highest levels seen in years. This is a case of high risk and limited reward.

The Dividend Yield

This might seem incredibly simplistic compared to much of my analysis, but sometimes the truth is staring us in the face. We need only to recognize it and accept it. The following chart shows the price and dividend yield over the last few years:

I had a buy rating on the common shares and established a position at the point identified by the green line. The rating was shared with subscribers first, but I brought out the public strong buy rating on October 24th, 2016. At the time, my analysis was focused heavily on the discount to book value. CMO was severely out of favor with analysts and investors. The premise for their bearishness was the collapsing net interest spreads. Ironically, that is precisely the argument I am making today.

The price is back to where it was about two years ago, when it started a fierce decline. The dividend yield on the other hand is only 8.33%, much lower than it was before. When we see the same price with a lower dividend yield, it reflects a lower dividend rate. CMO has been forced to cut its dividend due to the impact of both expected prepayments and actual prepayments.

Yields, Spreads, and Amortization

In the future, I want to put together a little series diving through the fundamentals of how CMO works. I think many investors today don't fully understand the mREIT. In the following slide, from its Q1 2017 presentation, I'm highlighting the yield on assets, the financing spreads, and the amortization. Don't worry; I'll explain each of those. For investors who want to access older presentations, use the index of presentations.

Here we go:

The most recent data is on the left and the oldest data is on the right. In the green, you can see the yield on all interest-earning assets was 1.67%. This is the highest level reported since Q1 2016. If it were a mere 3 basis points higher, it would be higher than any seen in the last two years.

On the third line down, you can see the finance spread. That is the yield on assets minus the cost of borrowing. That is trending higher because the Federal Reserve is raising the rate on short-term borrowings by offering to pay banks more interest on excess reserves. Those are payments made to banks to compensate them for not doing their job (lending money). When the Federal Reserve raises the short-term rate, the mortgage REITs must pay a higher rate to remain competitive.

So why hasn't the cost risen faster? Simple. CMO hedges out a material portion of its exposure.

So that leaves investors wondering: If CMO hedged part of its exposure to rising rates, why is there a problem?

The problem is that spread of .68 (from line 3) is not sustainable. The strength of the spread actually comes from the red box. That is the impact of premium amortization on the spreads. CMO is buying adjustable rate mortgages and paying more than par value for them. That is perfectly normal. Because it pays more than par value, say $102.50 for a mortgage with a balance of $100.00, it has to recognize the cost of that extra $2.50 over the life of the loan. If CMO didn't have to recognize that expense, the yield on assets would be 2.60%. That is shown one line above the red box. In the first quarter, CMO reported the lowest value of the last four quarters for this expense. It was reducing asset yields from 2.60% to 1.67%. This is referred to as 93 basis points. In the prior three quarters this ran 105, 106, and 96 basis points respectively.

I am convinced this expense will increase materially for Q2, Q3, and probably Q4 of 2017 compared to the values reported for Q1 2017.

Why Will Amortization Charges Increase?

The problem comes down to how quickly prepayments are coming in. We are entering a period where prepayments should be elevated. You're probably aware that short-term rates are increasing, right? How many homeowners do you recall talking to who are completely clueless about short-term rates increasing? At this point, I think it is fairly common knowledge.

That makes it less appealing to have an adjustable-rate mortgage. Homeowners who currently have those loans outstanding have an incentive to refinance into a fixed-rate mortgage. When that happens, the owner of the adjustable rate (such as CMO) is forced to eat the loss on paying more than $100 for the loan and then getting the $100 from the homeowner.

The yield curve is exceptionally flat right now. The rates on new fixed-rate mortgages are heavily correlated to the medium duration Treasury securities such as the 10-year Treasury. Consequently, homeowners with adjustable-rate mortgages should be receiving calls from their banks or credit unions offering to help them refinance into a new loan. It is in the banks' best interest to do that, because after they make the new loan, they can spin around and sell it off for somewhere around $102 to $105 per $100 on the loan. The buyer of the loan has to amortize that premium over time, but for the bank, it is immediate profits.

Therefore, I expect prepayments to increase. When the prepayments increase, I expect amortization charges to increase. Even though the gross asset yield, last seen at 2.6% should continue to climb, I expect the higher amortization charges to offset a material part of that growth. Consequently, I don't believe the "yield on all interest-earning assets" will increase much beyond 1.67% on average (remember, this is the green box at the top of the chart).

Because the higher amortization expenses should keep a lid on the yield on all interest-earning assets, even a slow growth in the cost of financing should be enough to eat into the net interest spread. Over the last year, the cost of financing increased 12 basis points. I think that is a reasonable projection for the next 12 months as well. Without the hedges, this could easily be 25 to 50 basis points.

If we see asset yields running roughly flat at 1.67% due to higher amortization charges offsetting growth in the gross yields, a 12 basis point increase in the cost of financing would chop their spread from .68 to .56. That would be a 17% decline in the net interest spread income, assuming the leverage remains steady.

What happens when that spread gets compressed? Dividends get chopped:

Rating on CMO's Common Stock = Sell

I see the potential pressure on the net interest spread as a major consideration for investors going into CMO. I was able to find value despite the issues when the yield curve was steeper and the company traded around $9.30 rather than $10.98. Now we are looking at a scenario where amortization expenses are more likely to go higher and net interest spreads are more likely to be compressed. Despite these challenges, the stock rallied significantly. This is a great time for investors to be harvesting gains. I know the ex-dividend date is almost here and some investors may feel inclined to hold on. Perhaps the market will ignore these problems for months longer, but I wouldn't want to play that game. There is far too much downside risk. I view CMO as a clear sell at this point.

Alternative

My concerns about CMO extend to other mortgage REITs in the same space. The adjustable-rate mortgages can be a great investment strategy, but they suffer when the yield curve flattens out and prepayments rise due to homeowners refinancing. As an alternative, I suggest (and own) shares of CMO-E. CMO-E is an excellent yield investment. Unlike CMO, there are no dividend reductions on CMO-E. When the yield curve flattens and net interest spreads decline, it doesn't impact CMO-E. The dividend yield on CMO-E is running about 7.6%, which is right around where it normally trades. Note: CMO-E traded up since I published this for subscribers. The stripped yield is now 7.5%.

An investor going from CMO to CMO-E would usually have to give up at least a couple hundred basis points in dividend yield. With CMO only yielding 7.65% and very little chance of an increase, the spread between the two is much smaller. If we use "current yield", which ignores dividend accrual, the yields would be 7.65% on the common and 7.36% (rather than 7.5%) on the preferred shares. This is a spread of only 29 basis points. It is easily the smallest spread I've seen between the common and preferred shares for CMO at any point.

Investors deciding between the two should consider the price volatility as one measure of risk. The following Google chart demonstrates it quite clearly:

Conclusion

Is the extra volatility in price worth it for an extra 29 basis points of yield? Is it worth the risk that dividends could still get pressured by amortization expenses while the Federal Reserve drives up the cost of borrowing on short-term loans? Picking winners on a consistent basis relies on finding less volatile opportunities where prices are steady and yields are high. At this point, the yield spread is exceptionally small and the price risk built into CMO is exceptionally high.

Want SMS alerts when I find an actionable opportunity? They are a free service for subscribers to The Mortgage REIT Forum. This is your opportunity to lock in prices at $330 per year before the next price increase on July 1st, 2017. These preferred shares are offering high yields and dramatically lower volatility than investing in the common shares.

Disclosure: I am/we are long CMO-E.

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.

Additional disclosure: No financial advice.

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