After experiencing the first rate cut in over a decade, markets started August very weak as participants speculated on the beginning of a larger rate cutting process that ends possibly with an economic contraction. In the weeks prior to the Fedmeeting, participants had been trying to decide whether this was an “insurance cut” or something more consequential. Equity prices across the three major indices produced pronounced negative returns. The S&P 500 finished lower by 2.5 percent, the Dow Jones Industrial Average was down 2.04 percent and the technology-heavy NASDAQ was down 2.6 percent. Safe haven instruments like bonds and precious metals continued to produce positive returns for the month. The 10- and 30-year US Treasuries ended the month yielding 1.5 percent and 2.03 percent respectively.
In last month’s letter, we discussed the openness of markets for new bond issuances by credit-worthy companies. We received some feedback from clients asking about a form of debt familiar to many: mortgages. Many wondered why mortgage rates did not appear to following the reduction in ten-year US Treasury rates, as they often do. In December of 2018, the ten-year Treasury was yielding close to 3.3 percent. Currently, the 10-year US Treasury’s interest rate has fallen more than half to trending just above 1.5 percent. Traditional mortgage for credit worthy buyers and refinancers continue to dwell in the mid-upper 3’s. There are a few, interrelated reasons why mortggage rates have decoupled from traditional trackers. First, the dynamic of mortgage underwriters have changed since the Great Recession of 2007-2008. Prior to 2007, the majority of mortgage origination came from Wells Fargo, Chase, Citi, Countrywide, and others. Currently, top mortgage lenders are Quicken Loans (of “Rocket Mortgage”), Wells Fargo, and United Shore. With the exception of Wells Fargo, these entities are nonbank servicers and therefore do not track the yield curve as closely. Interest rates from these nonbank servicers like Quicken and United Shore tend to respond more to secondary market liquidity—that is, debt-buyers. The secondary market is currently flush with mortgages (high supply). If the amount of supply is high relative to demand, interest rates will stay the same or increase depending on other secondary variables. The high supply of mortgages is due in part to the Federal Reserve’s continued paydowns. With the Federal Reserve offloading mortgages it purchased bought five to seven years ago, the net supply of mortgages is almost double the normal supply.
Please review the following updates from some of the existing positions that we manage:
MPLX Cumulative Preferred Stock— (CUSIP: 03350FAA4): For clients invested in this position, your July paper statement account values were under-reported by Fidelity. As a reminder from a previous letter, MPLX, the MLP of Marathon Petroleum, acquired and closed on their merger with Andeavor Logistics. Unfortunately, as the preferred stock was being reidentified, Fidelity reported the value of the preferred stock as “unavailable” which translates to $0. After the July paper statements were sent on August 3, the MPLX reidentification was completed and the position values were restored. This company is on a solid foundation. This merger was very accretive and will help increase the scale and credit profile of the new entity. Credit rating agency Fitch upgraded MPLX Long Term Issuer Default Rating to BBB from BBB-. This upgrade is a continuation what we have witnessed from the other major credit rating agencies over the past 90 days. It is possible we will add to the position but we are monitoring the company’s transforming focus to the Logistics segment of the industry. MPLX will cut investments in their natural gas processing segment to invest on integrating the logistics division with the new parent, Marathon Petroleum. We view this change of priority positively and, with several new large projects coming online over the next year, the company’s credit profile should continue to improve.
SemGroup / Rose Rock Midstream— (CUSIP: 77714PAB5): Widespread reporting indicates that this oil and natural gas pipeline owner is evaluating takeover interest from another party. Citigroup analyst Ryan Levine wrote that the company could generate a strong IRR (15-20 percent) on equity estimating a small premium from the current share price. About a month ago that the company, Mr. Levine noted that Rose Rock Midstream should be taken out by a larger, well-capitalized entity and “simplify” SemGroup’s portfolio. Annaly Capital Series F Preferred Stock— (NLY-F): The mortgage REIT (“mREIT”) sector has been a volatile industry over the last year with the big swings in interest rates. This industry relies on receiving cheaper short-term financing while investing that capital for higher yields and longer timeframes. Management teams of strong mREITS, can make transactions to lessen risks. As the yield curve tightens or inverts, the business model comes under understandable pressure. Particular for mREITs, comparing the amount of preferred stock outstanding (which we own) to the overall market capitalization of the business provides a good sense of the safety margin. For Annaly preferred shares, the ratio is strong.