UBS's new ETracs Monthly 2xLeveraged Mortgage REIT ETNs to attract high-yield seekers

By Emma Trincal

New York, Oct. 17 - Tapping into high-yielding mortgage REITs, UBS launched a new exchange-traded note, which sources said is the first exchange-traded product to offer leveraged exposure to the sector.

UBS AG, London Branch priced $10 million of ETracs Monthly Pay 2xLeveraged Mortgage REIT exchange-traded notes due Oct. 16, 2042 linked to the Market Vectors Global Mortgage REITs index, according to a 424B2 filing with the Securities and Exchange Commission.

The notes pay a monthly coupon linked to two times the cash distributions that a hypothetical holder of the index's constituents would have received during the month minus accrued fees.

The payout at maturity will be based on the monthly compounded leveraged performance of the index less accrued fees. The leverage factor is two, and fees include a 0.4% annualized tracking rate and a financing rate of Libor plus 40 basis points.

The index tracks the overall performance of publicly traded mortgage REITs that derive at least 50% of their revenues from mortgage-related activities.

Collect the coupon

UBS in a press release stressed the major selling point of the new product: its high monthly income potential. Calculated as of Sept. 30, 2012, the two-times index yield was 24.82%.

"That's way up there," said Andrew Valentine Pool, main trader at Regatta Research & Money Management. "It makes you wonder what the downside is. I haven't heard about it yet but I'm interested in looking at it and see what the risks are."

"This ETN is designed for investors who seek a high yield and are bullish on the mortgage REIT sector," said Paul Somma, senior structurer at UBS, in the press release.

The notes, which began trading Wednesday, have been approved for listing on NYSE Arca under the symbol "MORL."

"MORL offers high monthly income potential and leveraged exposure to a mortgage REIT index, all by way of a single, exchange-traded security."

A market participant said that: "The yield is what's interesting about the product. That's why people would buy it. You're not buying it for the price action. A 24% yield is incredible. Mortgage REITs right now offer higher yields than [Master Limited Partnerships]."

He said that the lower yields seen with MLPs were the result of their popularity.

"They used to yield 18%, but now they're a little bit overbought and yields have gone down."

"I think mortgage REITs are the new thing for yield. As the investment gets better in price, the yield eventually will get lower. But that's somebody else's problem if you buy it today. Right now, you have a yield north of 20%," he said.

The monthly income is variable as it is linked to two times the cash distributions, if any, of the index constituents.

"Clearly the companies can change the dividends any time and that's the risk," he said.

Mortgage REITs raise capital in the secondary market, primarily through the use of short-term loans, and use that capital to issue mortgages.

"They're borrowing at a lower rate than what they're investing at or they may borrow and invest in different tenors. They make a spread and they're required to distribute 90%. That's why they're paying such high yields," he said.

Little competition

Another advantage of the notes, he said, was their uniqueness as a leveraged exchange-traded product.

"To my knowledge, the only ETF tied to this particular index is MORT. But it's not leveraged," he said, referring to the Market Vectors Mortgage REIT Income ETF.

Another one, he said, was the iShares FTSE NAREIT Mortgage REITs index ETF, also a non-leveraged ETF and one based on a different index.

"There is not alternative with an ETF if you want to get two-times exposure to the Market Vectors Global Mortgage REITs index, he said.

The leverage itself, he said, offered additional benefits. He stressed the borrowing cost and the reset.

"The most interesting thing about the product is the cost," he said. "UBS' cost of funding is passed on to the investor."

"The annual tracking fee is 40 basis points. The leverage cost is Libor +40, so you can actually borrow money for 75 basis points. That is unbelievably competitive. It's a very compelling access to this leveraged yield."

Another advantage, he noted was the fact that leverage is reset monthly rather than daily.

When the reset is more frequent, tracking errors tend to increase, he added.

"Investors will only be reset 12 times a year versus 250 times. That's a major leap. It will make their return closer to what they expect their return to be. If my index return is 5% and I have double exposure, I would expect 10%. With a daily reset, there can be a significant gap and you could be far less than 10%. With the monthly reset, you may not get 10% exactly, but you should be close," he said.

Risks involved

The investment however is not without risk.

"It's ultimately a fixed income instrument," said Jim Delaney, portfolio manager at Market Strategies Management. "It will go down in price if you had exposure to rising rates. The yield may help offset the risk of the price action.

"You also have the credit risk of UBS.

"But if you can get at 40 basis points plus Libor two times the price and yield of this index, then you kind of do it because you are still ahead of everybody else."

"You just have to make sure you can sell whenever you need to," he said.

The notes are putable at any time, subject to a minimum of 50,000 and a redemption fee of 0.125%, according to the prospectus. They are callable in whole beginning Oct. 21, 2013.

The notes priced at par of $25. In the risk section, the prospectus said that "a trading market for the ETNs may not develop."

The prospectus also warned about the leverage risk. Investors are exposed to two times any negative performance of the index, before fees.

Delaney said that investors should have a short holding period or an active management style.

"If I can trade it every day, there is no reason for me not to own it. But you have to be fully aware of the leverage risk. You can lose twice more on the downside," he said.

"As rates go up, you could get creamed on the price front because it's a bond. The price would depreciate on a-two-times factor. You could get creamed also on the financing front because your borrowing cost is based on Libor," he said.

One risk inherent to mortgage securities - prepayment risk - was covered in the day's market, he noted. In fact, the current low interest rates environment was a plus for these types of products, according to Delaney.

"The saving grace here is that we're moving from a low rate environment into higher rates, so you're not going to see much of the securities disappear in prepay.

"It sounds like a very good idea for these investors that actively manage their portfolio. If you buy this thing and forget about it though, it's going to be dangerous."

The company plans to sell up to $100 million of the notes. The remaining $90 million will be sold from time to time at varying prices.

UBS Investment Bank is the agent.

The Market Vectors Global Mortgage REITs index, created in August 2011, currently consists of only U.S.-listed mortgage REITs. The top constituent is Annaly Capital Management Inc.

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