If you’re an investor in a publicly traded mortgage investment corporation (MIC), there are changes on the horizon that could impact your investment. They range from new regulatory restrictions to the effect of rising interest rates.
We recently asked Trez Capital Managing Partner Michael Nisker about each of these trends. The interview that follows may prove useful if you are in, or considering dabbling in, the high yielding public MIC market.
CMT: The Bank of Canada recently called MICs a “potential vulnerability” and part of the
shadow banking sector. It says it is monitoring MICs “closely.” Why do you think the BoC said that, and is there anything for taxpayers or MIC investors to worry about?
Michael: With the significant proliferation of public MICs issued over the past 18-24 months, there has definitely been a spotlight shone on the sector, from both investors and regulators. That said, we do not believe that taxpayers or MIC investors have anything to worry about with regard to the Bank of Canada’s comments on monitoring the sector closely. The Bank clearly stated it was looking at ways to “address the vulnerabilities” these corporations might pose, but at this point we don’t see a large vulnerability.
CMT: Securities regulators have proposed new rules that would bar some MICs from investing in mortgages without government loan guarantees. Does this have a high probability of becoming regulation? If so, which MICs will be affected (large, small, public, non-public)?
Michael: The Canadian Securities Administrator (CSA) has proposed new rules that would prohibit closed-end funds (public MICs) from investing in mortgages that are not guaranteed by a government insurer. We do not know the likelihood of the proposed rules becoming formal regulation. However, we have made a decision to be
proactive and have proposed to shareholders that both Trez Capital Mortgage Investment Corporation and Trez Capital Senior Mortgage Investment Corporation transition from that of an investment fund to that of reporting issuer that is a public corporation. We believe this will be in the best interests of shareholders.
CMT: What is the likely investor and company impact if these rules go through?
Michael: We do not believe that any of the proposed changes will necessarily positively impact investor protection since investors would still hold the same assets, just under a different legal structure. Ironically, under a public corporate regime there are fewer restrictions on investments and the use of leverage versus in the close-end investment fund space.
However, there could be some benefits due to the different way the markets price shares of a publicly-traded company compared to investment funds. Companies will have their share price set based on yield, rather than shares being anchored to the net asset value of the holdings. Also, as a public company, a MIC would be better positioned to attract research analyst coverage, which it currently doesn’t receive as an investment fund.
For investment funds that convert to a public company as a result of the proposed changes, there would be little to no impact on borrowers. For investors, we believe that there would be several other benefits. First, the elimination of the trailer fee will leave more of the income generated by the MICs to be available for distribution to investors. Second, shareholders would receive voting rights. Third, there would be increased frequency in financial reporting. Finally, there should be increased stability of capital resulting from the elimination of the redemption feature.
CMT: What is the average yield of all public MICs at the moment? How does this compare to other yield-paying investments on a risk-adjusted basis?
Michael: Public MICs are yielding in the range of 5.0 to 8.0 percent.
In the case of the Trez MICs, as of October 9, 2013, Trez Capital Junior MIC (TSE:TZZ) is yielding 7.9 percent (with a 68 percent loan-to-value ratio) and Trez Capital Senior MIC (TSE:TZS) is yielding 6.0 percent (with a 39 percent loan-to-value ratio). Note that the current loan-to-value ratios for both MICs are lower than what our investment restrictions allow them to be. We have been successful at managing the portfolios in a manner that meets the distribution targets at a reduced level of risk.
We feel this is an attractive risk-adjusted yield and compares favourably with other yield investments. The smaller, newly listed REITs typically yield approximately 7.00 percent, and the larger more established REITS 4.00 percent. Corporate bonds (as measured by the XCB) are currently yielding about 3.75 percent and Government of Canada bonds (as measured by the XGB) are currently yielding 2.89 percent.
CMT: If rates hypothetically increased 2.00% in the next two years, how could MICs be affected? Would private and public MICs be impacted differently?
Michael: While there is concern that rising interest rates would have a negative impact on MICs, we do not believe that is accurate. MICs generally have a low loan duration portfolio.
The extent to which MICs may benefit from rising rates depends on a number of factors. For example, if a lender charges its borrowers fixed rates, then they will be slower to benefit from rising rates. However, if a lender charges its borrowers floating rates, they will immediately benefit in a rising rate environment.
Trez is well positioned to benefit from higher rates as we primarily issue floating rate loans with short duration. In addition, our rates come with a floor, so if rates drop we are protected on the downside. However as rates rise we are able to raise our rates along with the rest of the market.
The effect on private versus public MICs comes down to the specific investment portfolio management strategy of the MIC itself.
CMT: What explains your downtrend in stock price since Q4 2012?
Michael: We believe that the downturn in stock price for both of our MICs, as well as other public MICs, can
be attributed to misplaced concern about rising interest rates as it relates to our products. The spectre of rising rates has negatively impacted the REIT sector, and we believe that investors have incorrectly placed MICs into the same category as REITS for this purpose.
Our fundamentals remain strong. Our performance results, as indicated through stable distributions with loan-to-value ratios lower than our investment restrictions allow for, suggest that our stock price is being incorrectly priced. We are executing on the strategies to continue to grow the fund and originate mortgages. We have a strong deal pipeline and believe that if rates do rise, we will benefit based on our short loan durations and floating rate loans.
We have deployed our capital and continue to hit our marks. We believe that as we continue to execute on our investment strategy and continue to build NAV, investors will realign the stock price with the risk-adjusted return potential our MICs provide.
Ed. Note: Public MICs have underperformed the TSX as a group in the last year, as this chart depicts. That has improved their yields notably, to over 7.0 percent on average.
CMT: Should investors be worried if management doesn’t own a material amount of stock in its MIC?
Michael: We believe that management should align their interests with investors. At Trez, our firm and its management have a significant amount of their personal net worth invested in the company’s investment strategies.
CMT: Do any MICs return investor capital as part of their distributions?
Michael: MICs do not distribute a return of capital in their distributions…Returns are treated as interest income.
CMT: Thank you Michael…
What is a MIC? Mortgage Investment Corporations (MICs) were created by the Federal Government in 1973 to allow investors to participate in a pool of mortgages on real property. MIC shares qualify for registered plans such as RRSPs, TFSAs, RDSPs, RRIFs and RESPs. MICs are a “flow-through” investment vehicle—meaning they must distribute 100% of their net income to shareholders.
Rob McLister, CMT