DMO: Another dividend hike on this 13.2% yielding mortgage CEF

On this article, we’ll take one other have a look at the Western Asset Mortgage Alternative Fund (NYSE: DMO) is a fund primarily meant for residential and industrial mortgage belongings. The fund has simply elevated its distribution for the fourth time time in a row, and we use this as a chance to supply an replace. We’ve lowered our stake within the fund however proceed to carry a small place in our excessive yield portfolio. DMO trades at a reduction of two.8% and a present yield of 13.2%.

Inventory photograph

The DMO distributes primarily non-agency residential mortgage loans, with a smaller proportion of economic mortgage loans. Residential allocations are roughly divided into three equal teams – legacy, new points, and risk-transferred securities, or CRTs.

The most important bucket within the distribution of economic mortgages is the so-called SASB, which means one asset, one borrower. These belongings are sometimes mortgages on particular person properties, akin to 280 Park Avenue, New York, which is a part of DMO’s portfolio. That is noteworthy as the broader workplace sector has struggled because of the altering nature of labor for the reason that pandemic. As a result of SASB securities are by definition non-diversified, this may end up in losses even for senior mortgage-backed securities.

For instance, tranche AAA holders of a $308 million mortgage-backed be aware at 1740 Broadway in New York Metropolis acquired again lower than three-quarters of their principal quantity. This seems to be the primary AAA CMBS loss for the reason that GFC. The constructing’s primary problem was its main and first tenant, L Manufacturers, which occupied practically 80% of the constructing by relocating. Regardless of the renovation, low demand for workplace actual property precipitated Blackstone to desert the property and default on the mortgage.

This isn’t to say that the DMO has or could have issues. Judging by its efficiency over the previous yr when it comes to web revenue and NAV figures, it has no issues on that entrance. Nonetheless, it is an space worthy of consideration.

Greater than 70% of the fund’s portfolio is unrated, which isn’t uncommon for older mortgage belongings. The score profile has not modified considerably during the last yr. There was some migration within the decrease high quality buckets with a discount in CCC holdings and a rise in CC rated holdings.

Updating the fund

The fund’s quarterly web earnings figures are proven within the desk under. The latter determine of $0.31 represents 10.23% of web funding earnings from NAV. This was a major leap of 19% in comparison with the earlier quarter.

Regular, if uneven, progress in web earnings over the previous few years is essentially a operate of a major quantity of floating price holdings – about 80%, web of inverse floating. This driver has now been exhausted, as short-term charges have been unchanged for a couple of yr.

One other issue within the progress of web revenue is the rise in borrowings. The fund added borrowings throughout the quarter by about 9% (19% year-on-year), which is able to enhance earnings, however not by a lot, as greater than half of gross earnings will go to credit score prices and administration charges, ie. A % improve in borrowings will result in maybe a 3-4% improve in web funding earnings.

The 19% quarter-on-quarter leap in web earnings can’t be defined by adjustments in borrowing, short-term charges or positioning, so we suspect web earnings will decline subsequent quarter, because it did within the December quarter.

By way of efficiency, DMO has outperformed the typical multi-sector CEF over the previous 3 years by 1.4% per yr. It has gotten a bit of worse over the previous yr.

The fund’s distribution is up 30% from its 2022 low and about 7% under its 2010 degree, when it started buying and selling. Decrease short-term charges are prone to end in a drop in web earnings and potential layoffs.

The fund has traditionally purchased again shares when its low cost is excessive. For instance, he purchased again 13,982 shares within the second quarter of final yr (82,000 shares since inception). This not solely will increase the NAV but in addition helps the share worth. It additionally exhibits that administration is prepared to chop charges to profit shareholders.

One other engaging characteristic of the fund is its capacity to diversify portfolios which might be usually obese company credit score danger by company bonds and loans. Many of the portfolio is uncovered to home dangers, and this space of ​​the financial system has been comparatively robust. Furthermore, family debt has fallen considerably over the previous 15 years, whereas company debt has risen and now exceeds family debt.

Over the previous yr, the fund’s low cost has elevated considerably each in absolute phrases (left chart) and in relative phrases (proper chart), main us to scale back our place within the high-yield portfolio. We’ll contemplate rising the place if the low cost returns to the excessive single digits.