One of the most important concerns for many investors in the Mortgage REIT sector deals with the concept of prepayment risk. According to Investopedia.com an example of 'Prepayment Risk' is as follows:
On a mortgage-backed security, the higher the interest rate relative to current interest rates, the higher the probability that the underlying mortgages will be refinanced. Investors who pay a premium for a callable bond with a high interest rate take on prepayment risk.
When the number of prepayments increases, it causes somewhat of a domino effect and negatively affects variables such as spreads, profits, and revenues begin to shrink significantly. Given the fact that prepayments have been demonstrating a sharp increase during the third quarter, many investors are seeing an even sharper decline in spreads, profits and the precious high-yields of many of these securities in the coming months. Investors should note that since 2011, Annaly Capital (NYSE:NLY), American Capital (NASDAQ:AGNC), Chimera Investment (NYSE:CIM) and CYS Investments (NYSE:CYS) have all reduced their respected dividends multiple times as a result of the increase in prepayments. Prepayments, however, aren't the only reason why investors should avoid the sector at current levels. In my opinion, there are several key variables to consider such as QE3 performance and dividend behavior, before establishing a position.
Performance since QE3
On September 13th the Federal Reserve is strengthening its role as pseudo-Mortgage REIT, as it announced to purchase an additional $40 billion of mortgage backed securities each month. These additional purchases are pretty much open-ended and no expiration date has been established. Since that announcement, the Mortgage REIT sector has shown a considerable decline. For example all four of the above mentioned Mortgage REITs have fallen by an average of 13.66%.
Change Since 9/13/12
If the Fed continues to buy up mortgages at such a torrid pace, I strongly believe we could see an even further decline in the price of these securities. One of things currently being discussed is the idea if diversification. For example, Annaly Capital recently announced it was planning to acquire the outstanding shares of CreXus Investment Corp. (NYSE:CXS) and I think that if the Fed continues to engage in such behavior similar acquisitions could happen in the next 6 - 12 months.
Do Mortgage REITs such as Annaly Capital, CYS Investments, American Capital Agency, and Chimera have the means to compete with the Fed? Operation Twist is far from over, and the purchasing of bonds at the longer end of the maturity spectrum continues to force the 10-year Treasury rates down. This reduces the spread between the short end and the long end, making the spread needed for these Mortgage REITs to profit to an extent that it can maintain its business model and its profitability. If the yield curve flattens, profits become squeezed and dividends could be cut more than they have been recently.
Will the Mortgage REIT sector survive, given the current political landscape? I don't see Mortgage REITs evaporating come January 1st, but I do think the double-digit yields that high-yield investors love to chase will soon be few and far between come 2013. If the number of prepayments continues to rise and the yield curve continues to feel pressure, 7.00% - 9.00% yields may be much more common than the yield we see at current levels.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.