The Implications Of The Collapse In The MORL-MRRL Spread

The MORL-MRRL spread fell to only $0.06 on Oct. 21, 2019.

The zero commission policy adopted by many major brokerage firms was probably a contributing factor to the collapse in the MORL-MRRL spread.

The zero commission policy may have implications for investor behavior, not now apparent.

MORL, MRRL, and REML will pay higher than unusual monthly dividends in November 2019, due to some special circumstances.

I have written about a portfolio where the most important constraint is to only include securities with current yields above 15%. Other constraints are the typical retail IRA account restrictions which preclude the use of short-selling, margin borrowing, most options strategies and futures contracts. Some brokerage firms also impose additional constraints on IRA accounts. I suspect that there are many individuals, particularly those either partially or totally retired, who either have somewhat similar constraints or they might possibly benefit from adopting them. There is nothing magic about the 15%+ current yield threshold. Originally, in 2001, it was a 10% current yield threshold. It reached 30% in 2008 and 60% in March 2009.

UBS ETRACS Monthly Pay 2X Leveraged Mortgage REIT ETN (MORL) and, later, UBS ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN Series B (MRRL) and the Credit Suisse X-Links Monthly Pay 2x Leveraged Mortgage REIT ETN (REML) have been the core instruments in my 15%+ current yield constrained portfolio. These are 2x-leveraged mREITs High-Yield ETNs. Other than junk bonds and other securities issued by individual distressed entities, in order to meet the 15%+ constraint, my primary investment focus in the quest for 15%+ current yield has been and is, on 2x Leveraged High-Yield ETNs.

As described in my 2013 Seeking Alpha article, "A Depression With Benefits: The Macro Case For mREITs," my macroeconomic rationale for investing in MORL- the only 2x leveraged mREIT ETN in existence at that time - was based on the premise that government policies shifting the tax burden from the rich and onto the middle class results in much more funds being available for investment relative to productive uses for those investable funds. That was one reason I concluded that interest rates would be relatively lower for longer than most market participants were predicting.

Another reason for my view that interest rates would not increase as much as the consensus, was based on the premise that the Federal Reserve was not artificially reducing interest rates, as most believed, but rather keeping rates higher than a free market in risk-free securities would otherwise result in. This was put forth in another 2013 Seeking Alpha article: "Federal Reserve Actually Propping Up Interest Rates: What This Means For mREITs." Thus, originally I focused only on securities with significant interest rate risk but not much credit risk.

I have recently taken small positions in two additional UBS 2X Leveraged ETNs: The ETRACS 2x Monthly Leveraged S&P MLP Index ETN Series B (MLPZ) and The ETRACS 2x Monthly Leveraged Alerian MLP Infrastructure Index ETN Series B (MLPQ). Unlike MRRL, the inclusion of "Series B" in the names of MLPZ and MLPQ does not indicate that there are companion UBS 2X Leveraged ETNs for MLPZ and MLPQ, as is the case with MORL and MRRL. My decision to buy small amounts of MLPZ and MLPQ was prompted by their decline in price and the increase in resulting increase in current yield, now around 19% for each as per UBS, additionally as is further discussed below, the recent reduction in retail commissions to zero, has impacted the behavior of some investors including me.

At this point in time, my purchase small amounts of MLPZ and MLPQ, does not indicate that I have followed the adage "investigate and then invest" with regard to them. I have not done significant research into them. Rather, it is a related to my belief in what George Goodman, who wrote and appeared on television under the name "Adam Smith" said: if you want to really learn about something, take a financial stake in it. As an example, he said, buy one corn future on the Chicago Board of Trade and you will find yourself up at 4:00 AM in the morning looking at weather patterns in Iowa.

Unfortunately, for me, and possibly for my readers at this point, Mr. Goodman said that prior to the internet and the tremendous amount of interesting information and opportunities to do fascinating research it provides. Also, as many people who are retired or semi-retired find out, there is not nearly enough available time for those books and other projects you thought could be easily finished after you stop working full-time. That said, I have purchased small amount of various securities for the express purpose of learning a lot more about them so that I could research and evaluate their use as possible diversifiers in the 15%+ current yield constrained portfolio and also write about them. However, I found that alone does not create the time necessary to research them as much as I would like. Other high yielding securities that I have taken this approach with were discussed in the article "More Candidates For The 15%+ Current Yield Portfolio."

Sometimes events that initially might appear unrelated, do in retrospect suggest a cause and effect relationship. MRRL is essentially an identical twin to MORL. Until September 6, 2018, MORL and MRRL usually traded very close to each other and to their net indicative (asset) value, which is identical for both. The price relationship between MORL and MRRL changed after September 6, 2018. UBS then announced that they would no longer issue any new shares of MORL. While typically called "shares," ETNs are actually notes. The price of MRRL has continued to closely track net asset value since that announcement. However, MORL began trading far above MRRL (and the net asset value of both). The spread between MORL and MRRL eventually widened out to $0.97 on September 17, 2018.

This enormous spread prompted my article "Sell MORL, Buy MRRL," which noted:

The spread between MORL and MRRL narrowed dramatically soon after the article appeared on Seeking Alpha. The spread has bounced around since then, with MORL generally trading higher than MRRL. The chart below shows the MORL-MRRL spread for the period after September 6, 2018. On June 26, 2019, the spread closed at an all-time high of $1.45. One October 21, 2019 the MORL -MRRL declined to $0.06. The deviation of MORL from MRRL is best thought of as a deviation of MORL from its net indicative (asset) value. Since MRRL is being created and can be redeemed by professionals at net indicative (asset) value, MRRL always trades very close to MORL's and MRRL's net indicative (asset) value.

MORL and later, MRRL and REML have been the primary instruments by which I have attempted to utilize my longer-term macroeconomic interest rate outlook to manage a portfolio constrained to only include securities with 15%+ current yields. MRRL is essentially an identical twin to MORL. REML is based on the FTSE NAREIT All Mortgage Capped Index of mREITs. That's the same index used by the iShares Mortgage Real Estate Capped ETF (REM). As can be seen in the Tables I and II below, the index that REML is based on is a slightly different index of mREITs, than that upon which MRRL and MORL are based, which is the MVIS® US Mortgage REITs Index. Thus, I have used REML as a somewhat interchangeable substitute for MRRL and MORL.

The deviation of MORL from MRRL is best thought of as a deviation of MORL from its net indicative (asset) value. Since MRRL is being created and can be redeemed by professionals at net indicative (asset) value, MRRL always trades very close to MORL and MRRL's net indicative (asset) value. The deviation of MORL from net indicative (asset) value also drives the spread between MORL and REML discussed in "REML Yields More Than MORL, But Trading Them Can Be Tricky."

The Chart I below shows the MORL-MRRL spread and the period where major brokerage firms began to adapt zero commissions, in light blue. I do not think the decline in the spread to $0.06 on October 21, 2019, is unrelated to the zero commissions. I generally never consider arbitrage transactions when the transactions costs would likely be more than half of the potential gain from the transaction. Transaction costs include commissions and bid/ask spreads. When dealing with small holdings, it is usually the commissions that are the bulk of the transactions costs. I have a number of small MORL positions, that I never considered switching into MRRL or REML even when the spreads were at very high levels, since commissions made such arbitrage trades uneconomic. I think the collapse of the MORL-MRRL spread was prompted by many holders who were holding MORL, but had held off on switching to MRRL, because they were unwilling to incur the commissions that such switching would entail.

When the zero commissions were being adopted by major brokerage firms in early October 2019, there was a period when Fidelity had not yet adopted them. As many Seeking Alpha readers and commenters quickly learned, if a customer called Fidelity and asked for it, Fidelity would give the customer a number of free trades as an interim policy, while Fidelity was considering joining the zero commission parade. I was given 25 free trades by Fidelity during that period. Fidelity has since joined the others and now has zero online equity commissions.

When I was given 25 free trades by Fidelity, I looked to "try out" the free trades. This prompted the MLPZ and MLPQ trades discussed above. In the 15%+ current yield portfolio I had been building small positions in the very thinly traded: Select Asset Inc 7 % Corporate Backed Callable Trust Certificate 2007-1.3.97 Cl A-1 Ser 2007-1 7 5/8 (JBN) and Select Asset Inc 7 % Corporate Backed Callable Trust Ctf 2006-1.3.97 Cl A-1 Ser 2006-1 (JBR). These are both among the various trust preferred "baby bonds" based on J.C. Penney (JCP) bonds 7.625% due March 1, 2097, which I also own. These J.C. Penney bonds are trading around 30% of face value, which is a 25% yield to maturity and are obviously very risky.

The baby bonds were issued by retail oriented firms in denominations of $25, when JCP debt was still investment grade, and now have current yields around 30%. The purpose of buying JBN and JBR was my hope to replicate the arbitrage profits I had made with similar baby bonds based on Ford (F) 7.45% bonds due July 16, 2031. At one point the F baby bonds were trading around $2.50, which was 10% of face value. Alas, all of the F baby bonds have been called at the $25 call price.

The spread between JBN and JBR has traded at levels that would have made arbitrage attractive if I had larger positions, but those trades were not done because commissions made such small trades not worthwhile. There are probably a number of possible arbitrage-type and other trades, that did not make sense before zero commissions, but now do. The Chart I below suggests that switching out of MORL and into MRRL was a trade that became attractive for many, as zero commissions became the norm.

MORL-MORL, Inception of Zero Commissions

The MORL-MRRL and REML-MORL spreads are not the only one involving 2x-leveraged ETNs. Various arbitrage opportunities exist in the 2x-leveraged ETN sector. MORL and ETRACS Monthly Pay 2x Leveraged U.S. Small Cap High Dividend ETN (SMHD) have at times traded far above their respective net indicative (asset) values. Generally, as long as MORL and SMHD are significantly above their net indicative (asset) values, new purchasers should avoid MORL and SMHD, in favor of MRRL and UBS ETRACS Monthly Pay 2xLeveraged US Small Cap High Dividend ETN Series B (SMHB), 2X-leveraged monthly pay ETNs that are based on the same indexes as MORL and SMHD, respectively. The index upon which SMHB and SMHD are based, the Solactive US Small Cap High Dividend Index, contains a fair number of mREITs that are also in the indexes upon MORL, MRRL, and REML are based. Thus, SMHB and SMHD could be a way to achieve high yields from mREITs as well.

Regarding SMHB and SMHD, it should be noted that they are more volatile than MORL, MRRL, and REML, even though SMHB has more than double the numbers of components of the other 2x-leveraged ETNs. This seems to be the nature of some of the components in the Solactive US Small Cap High Dividend Index, upon which SMHB is based. As was discussed in "Prospects For The Double-Digit Yielding ETNs":

More sophisticated traders might try to trade both ways when the spreads deviate from the means by close to two standard deviations. Likewise, traders may want to play the spread between MORL and SMHB as discussed in "The Most Bullish Thing For A 2X Leveraged High-Yield ETN." Holders of 2x-leveraged ETNs have usually experienced a windfall when the sponsor ceases sales of newly created notes, and a twin 2X-leveraged ETN, based on the identical index, exists. Holders of such 2x-leveraged ETNs should recognize that a potential windfall exists and consider what strategies they will employ to take advantage of the potential windfall. It should be kept in mind that the windfall will disappear, if the old 2x-leveraged ETNs are held long enough, since, at some point, all 2x-leveraged ETNs will be only worth above their respective net indicative (asset) values. This will be when they are redeemed, either prior to maturity or at maturity.

One consideration is that it is unlikely that 2X Leveraged Mortgage REIT ETNs will pay their $25 face value at maturity. They will pay whatever the net indicative (asset) value is at the maturity date. That is not as scary as it might sound.

As is explained in "Applying Net Present Values And Internal Rates Of Return To 2X-Leveraged ETNs Yielding More Than 20%":

Lower LIBOR rates would alleviate this concern, since, at current levels, the implicit LIBOR interest expense comprises most of the total expenses and fees that are deducted from the net indicative (asset) value of a 2x Leveraged High-Yield ETN.

The prospect of weaker economic growth has already caused the Federal Reserve to cut interest rates, much sooner than many had forecast during the last 8 years. The consensus now is that the next move by the Federal Reserve will be to further lower rates. However, 2X-leveraged mREIT-based ETNs have generally declined along with the equity market when protectionist policies and trade-war fears have roiled stock markets. That has occurred even though mREITs, mortgages and mortgage-backed securities that are held by mREITs, would generally not be impacted by trade policy related risks as much as would be the case with many other sectors of the economy and securities that are related to those sectors. Possible reasons for this are discussed in "mREITs Are Underperforming As Interest Rates Decline. Why?"

As was discussed in "Bank Issues Could Impact 20% Yielding ETNs," a French court ordered Switzerland's largest bank, UBS, to pay 4.5 billion euros ($5.1 billion) in fines and damages for helping wealthy French clients evade tax authorities. It is not inconceivable that zealous government authorities could impose such draconian fines and penalties, so as to cause the demise of one or more major financial institutions. That could impact the world economy in a way similar to the collapse of Lehman in 2008. Also relevant is that UBS is the sole source of the interest and principal payments made by the ETNs it sponsors. The ETNs are notes and, thus, obligations of UBS.

Even without any enforcement action, UBS could suffer such credit losses in a severe economic downturn, so as to impair their ability to pay their obligations to the holders of 2X leveraged ETNs. Another concern relating to UBS is the negative interest rates in Europe. UBS is the world's largest asset manager. The negative interest rates have caused UBS to charge large clients a fee to keep cash in their accounts. Some such investors have already taken their cash out of UBS and have literally put pallets filled with 500 euro notes into vaults.

My projected November 2019 MORL and MRRL monthly dividend of $0.1215 is a function of the calendar. Most of the MORL and MRRL components pay dividends quarterly, typically with ex-dates in the last month of the quarter and payment dates in the first month of the next quarter. The January, April, October, and July "big month" MORL and MRRL dividends are much larger than the "small month" dividends paid in the other months. Thus, the $0.1215 MORL and MRRL dividend paid in November 2019 will be a "small month" dividend.

As can be seen in Table I at the end of the article, only four of the MORL and MRRL components - AGNC Investment Corp. (AGNC), Colony Credit Real Estate (CLNC), ARMOUR Residential REIT (ARR), and Dynex Capital Inc. (DX) - now pay dividends monthly. Five of the quarterly payers will have ex-dates in October 2019. Thus, they will contribute to the dividend paid in November 2019. Those five are: New Residential Investment Corp (NRZ), PennyMac Mortgage Investment (PMT), Hannon Armstrong Sustainable Infrastructure Capital Inc. (HASI). Granite Point Mortgage Trust Inc. (GPMT) and KKR Real Estate Finance Trust (KREF). While typically called dividends, the monthly payments from the 2X-leveraged mREIT-based ETNs are technically distributions of interest payments on the ETN notes based on the dividends paid by the underlying mREITs that comprise the index, pursuant to the terms of the indenture.

Having five of the quarterly payers with ex-dates in October means that the $0.1215 November 2019 dividend will be one of the highest of the eight "small" dividends this year. The November 2018 dividend MORL and MRRL monthly dividend was only $0.1013. The Table I below shows the ticker, name, weight, price, dividend, and ex-date for all of the components. Additionally, the table includes the contribution to the dividend for the MORL and MRRL components that will contribute to the November 2019 dividend.

The VanEck Vectors Mortgage REIT Income ETF (MORT) is a fund that is based on the same index as MORL and MRRL. MORT pays dividends quarterly rather than monthly. As a fund, the dividend is discretionary by the fund management as long as it distributes the required percentage of taxable income to maintain its investment company status. Thus, it does not lend itself to dividend projections as an ETN like MORL or MRRL, which must pay dividends pursuant to an indenture.

My projected November 2019 REML monthly dividend of $0.2487 is a function of the calendar. As is the case with MORL and MRRL, most of the REML components pay dividends quarterly, typically with ex-dates in the last month of the quarter and payment dates in the first month of the next quarter. The January, April, October, and July "big month" MORL and MRRL dividends are much larger than the "small month" dividends paid in the other months. Thus, the $0.2487 REML dividend paid in October 2019 will be a "small month" dividend.

My projected November 2019 REML monthly dividend of $0.2487 will be the largest "small month" dividend ever paid by REML. For example. in November 2018 REML paid a monthly dividend of only $0.145. The reason that the November 2019 REML monthly dividend of $0.2487 will be the largest "small month" dividend ever, has to do with the composition of the index upon which REML is based, with regard to the months that each component has ex-dividend dates.

As can be seen in Table II at the end of the article, only five of the REML components - AGNC Investment Corp. (AGNC), Colony Credit Real Estate (CLNC), ARMOUR Residential REIT (ARR), Orchid Island Capital Inc. (ORC) and Dynex Capital Inc. (DX) - now pay dividends monthly. Five of the quarterly payers. will have ex-dates in October 2019. Thus, they will contribute to the dividend paid in October 2019. They will contribute to the November 2019 dividend. Those five are: New Residential Investment Corp. (NRZ), PennyMac Mortgage Investment (PMT), Hannon Armstrong Sustainable Infrastructure Capital Inc. (HASI). Granite Point Mortgage Trust Inc. (GPMT) and KKR Real Estate Finance Trust (KREF).

Table II shows the ticker, name, weight, price, dividend, and ex-date for all of the components. Additionally, the table includes the contribution to the dividend for the REML components that will contribute to the November 2019 dividend.

The iShares Mortgage Real Estate Capped ETF (REM) is a fund based on the same index as REML, rather than a note and does not employ the 2X leverage that REML does. REM also pays dividends quarterly rather than monthly. As a fund, the dividend is discretionary by the fund management as long as it distributes the required percentage of taxable income to maintain its investment company status. Thus, it does not lend itself to contribution by component dividend projections as an ETN like REML, which must pay dividends pursuant to an indenture.

My view is that Trump's removal would be a significant positive for the equity markets. In Nixon's case, there were never any articles of impeachment actually enacted and thus no trial. Nixon resigned and was given a full pardon by President Ford. Given the focus over the last year, regarding the issue over whether a sitting president can be indicted, a Trump resignation, in return for full pardon cannot be totally ruled out. As with Nixon, if the facts lead some of Trump's most ardent supporters to urge his resignation, this could spare the country and financial markets the turmoil of a trial. Of course, then the country and financial markets might start to worry about the possibility of the Democrats enacting some of the harmful policies and social programs that have been tried and, in many cases, subsequently rejected in Europe.

On balance, I still tend to believe that the massive tax policy-induced increase in inequality will cause increasing excesses of loanable and investable funds, above commercially reasonable ways to utilize those funds. This will eventually result in an over-investment cycle with a recession, and that should ultimately be very good for the mREITs and 2X-Leveraged ETNs based on mREITs. Some market participants recently seem not to believe that a possible recession will necessarily be good for mREITs. I believe that this misperception by the markets mostly present a buying opportunity, and I am adding to my holdings of MRRL and REML, in addition to continuing to switch out of MORL into the others. However, there are some real reasons why some market participants might be correct in their pessimistic perception of how mREITs will behave in a recession. This suggests diversification may be even more important than usual. In any case, it's always good to remember, as Keynes famously said: "The market can stay irrational longer than you can stay solvent."

Holders of MORL and SMHD should consider when to switch to MRRL, REML, and SHMB. Selling MORL or SMHD and using the proceeds to buy MRRL, REML, and SHMB will usually result in an immediate increase in current yield. However, waiting for the spread to be even more favorable could be even more advantageous. This suggests that not switching your entire position at any one time may be a better course of action. Small holders might find that zero commissions now make some trades feasible that were not so previously.

More sophisticated traders might try to trade both ways when the spreads deviate from the means by close to two standard deviations. Likewise, traders may want to play the spread between MORL and SMHB as discussed in "The Most Bullish Thing For A 2X Leveraged High-Yield ETN." Holders of 2x-leveraged ETNs have usually experienced a windfall when the sponsor ceases sales of newly created notes, and a twin 2X-leveraged ETN, based on the identical index, exists. Holders of such 2x-leveraged ETNs should recognize that a potential windfall exists and consider what strategies they will employ to take advantage of the potential windfall. It should be kept in mind that the windfall will disappear, if the old 2x-leveraged ETNs are held long enough, since, at some point, all 2x-leveraged ETNs will be only worth above their respective net indicative (asset) values. This will be when they are redeemed, either prior to maturity or at maturity.

The phenomena of the old 2x leveraged high-yield ETN trading significantly above its net indicative (asset) value, after new sales are suspended, while the new one trades very close to its net indicative (asset) value, means that the holders of the old 2x leveraged high-yield ETN can possibly receive a windfall when new sales of it are suspended. Thus, a consideration when choosing how much of any 2x leveraged high-yield ETN to own is the probability that sales might be suspended by the issuer at some point in the future. In the 2X-Leveraged ETNs based on mREITs sector, this could apply to REML.

One reason that sales might be suspended by the issuer could be to allow its brokerage arm to generate essentially risk-free income that would not require any outlay of cash, if hypothecated shares were shorted. I think it is likely that some customers of UBS might have hypothecated shares of 2x leveraged high-yield ETNs in their accounts. Paine Webber, a large retail brokerage firm, was acquired by UBS in 2000.

Table I: MORL and MRRL Components and Contributions to the Dividend

Table II: REML Components and Contributions to the Dividend

I am/we are long MORL, MRRL, REML, SMHB, JBN, JBR, KTP, AGNC, ORC, REM.

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.