In this post, we take a look at the Western Asset Mortgage Defined Opportunity Fund (DMO), trading at a 10% current yield and a 9.6% discount to NAV.
The allocation profile of the fund is fairly unusual in that it primarily holds mortgage securities with a greater focus on residential mortgages. These securities are not the more common agency MBS which carry no credit risk. Rather, they are either legacy non-agency securities (i.e. those issued prior to the GFC) or CRT securities (issued by US housing agencies after the GFC to offload borrower credit risk). This allocation profile makes DMO fairly unique in the CEF space.
DMO has a very attractive income profile for the current environment. The fund does a good job breaking out its floating-rate holdings in its report which makes it easier to gauge how its fund profile will evolve in the near term.
First, about 80% of the fund’s net holdings are linked to short-term rates. In an environment of unusually sharp Fed rate hikes, this is an attractive element of the fund’s income profile. The 80% figure is net of a small number of inverse floating-rate securities whose coupons are inversely related to rates i.e. their coupons decrease when rates move higher.
Two, the fund’s floating rate assets are almost exclusively tied to 1-month Libor. This has two benefits. First, unlike 3-month Libor or 3-month term SOFR which is the primary base rate for most loans and preferreds, 1-month Libor (and its eventual replacement) resets monthly while 3-month floating-rates reset quarterly. This means that the fund’s income will more quickly reflect the Fed’s hiking trajectory. And while it’s true that 1-month Libor trades at a lower-level than 3-month Libor (due to the averaging of the rising Fed Funds rate), the two rates will converge once the Fed reaches the peak in its hiking rate.
Three, the predominant lack of Libor floors means the fund’s income trajectory is stronger with more of the rise in Libor getting passed through earlier. This is unlike the behavior of traded and private loans (i.e. those held by loan CEFs and BDCs) which only pass through the rise in Libor above the level of 0.5-1.5%. This means that DMO enjoyed a rise in its income pretty much from the start of the year.
Four, the fund did something very unusual and good in 2021 – it fixed its borrowing costs until May 2023 by moving from a floating-rate borrowing facility to a fixed-rate repo with an average rate of about 1.89%. To provide some context here – most taxable credit funds are paying over 3% on their borrowings (i.e. roughly 3M Libor + 0.8%) and this will continue to rise above 4% as the Fed’s policy rate is expected to move north of 3%.
Five, the fund has significantly increased its borrowings from the trough in 2020 which will clearly continue to add to its income. The fund’s relatively muted NAV drop this year of 9.8% is well below the 15.8% average of the Multi-sector space and about half of the PIMCO taxable suite. This low-beta NAV profile should allow the fund to maintain its borrowing profile rather than force it into a deleveraging, something we have already seen in the higher-octane PIMCO funds.
Overall, DMO presents an attractive choice in the multi-sector credit space for income investors. Its household risk profile is a diversifier in most income portfolios which are likely overweight corporate credit risk, at a time when housing equity is high and household balance sheets are relatively clean. The fund’s floating-rate profile will benefit from rising short-term rates (without putting a strain on the issuers of its holdings or households who are primarily in fixed-rate mortgages). Finally, its fixed leverage cost and attractive valuation offer additional arguments for an allocation.
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