The third round of quantitative easing also known as QE3 was launched by the Federal Reserve in September to stimulate the sluggish U.S. economy. Under the new round, the Fed aimed at purchasing $40 billion Agency mortgage backed securities each month with no expiry date. Through QE3, Fed seeks to bring down the stubbornly high U.S. unemployment rate and support the recovering U.S. housing sector.
Effectiveness of QE3
Some said the much-awaited third round of quantitative easing was another attempt to bail out the large U.S. banks, while the rest are of the opinion that it will not be as effective in stimulating the U.S. economy as expected. Soon after the launch of QE3, Dallas Fed President Richard Fisher raised concerns about the effectiveness of the program with regards to job creation. The graph below shows that U.S. unemployment has actually gone up 10 basis points since the launch of QE3. It is evident that the new round of quantitative easing has not been very effective as far as job creation is concerned.
Another objective of QE3 was to support the recovering U.S. housing sector. I believe the new round has been fairly successful in meeting this objective. The large-scale acquisition of MBS has led to an upward pressure on their prices, decreasing their yield. Where it has led to cheaper borrowing or refinancing for homeowners, it has compressed the net interest margins for pure play mortgage REITs. The graphs below show how QE3 drove down the 30-year and 15-year mortgage rates to their recorded history lows.
It also helped mortgage originations, refinancing go up 30% compared with the linked quarter. Mortgage originations, refinancing during the second quarter were $263 billion, while it increased to $342 billion during the third quarter. Mortgage refinancing surged to highest levels since 2009. New mortgage originations of $471 billion were up 19.24% from the linked quarter. Existing home sales of $4.79 million during the month of October were up 2% sequentially. The rising home rents and the ultra low mortgage rates have pushed consumers away from renting homes and toward purchasing them.
This support to the U.S. housing and mortgage markets is aiding the banking sector, however, it's hurting the U.S. mortgage REITs sector, and particularly the mortgage REITs that are pure play in Agency mortgage-backed securities with little prepayment protection. First, I look at the impact of QE3 on the mortgage REITs sector and then look at some of the major U.S. mortgage REITs that would be hurt least.
Mortgage REITs Sector
- Following the Presidential election, the mortgage REITs sector continues to be weak, with the sector down 10% since then. During the quarter, the book values have softened, the magnitude of mortgage REITs sell-off exceeds that decline, making the sector attractive with potential of high-dividend yield and capital appreciation.
- So far in the fourth quarter, book values have gone down 2% due to the weakness in Agency MBS. However, given the stability in non-agency MBS, hybrid REITs have performed better.
- Since the announcement of QE3 by the Fed, Agency MBS yields have gone down 40 basis points. Thirty-year Agency MBS yields hover around 2 - 2.2%, while yields on 15-year MBS are in the range of 1.3-1.4%. Non-agency MBS offers yields in between 4-6% currently.
- So far in the fourth quarter, Agency MBS spreads have widened by 21 basis points to 42 basis points.
Therefore, I favor mREITs with prepayment protected portfolios, like American Capital Agency (AGNC) and Invesco Mortgage Capital (IVR), non-Agency mortgage REITs, like PennyMac Mortgage Investment Trust (PMT) and hybrid REITs like Two Harbors (TWO).
Invesco Mortgage Capital
Invesco Mortgage Capital operates as a hybrid mortgage REIT. The company's hybrid strategy enables its investment portfolio to benefit from Fed's MBS purchasing program. The company has $18.3 billion interest earning assets at the end of the third quarter, against $16.0 billion at the end of the second quarter of the current year. The following graph below shows the abundance of Agency Residential mortgage backed securities in Invesco Mortgage Capital's investment portfolio. Around 14% of the portfolio is composed of non-agency residential mortgage backed securities that have higher yields compared with Agency MBS.
The stock offers a dividend yield of 12.6% that is well backed by an operating cash flow yield of over 17%. The operating cash flow yield shows that the company generates sufficient cash to support the dividend distribution. The stock trades at a moderate discount of 2% to its book value.
American Capital Agency
American Capital Agency stands as one of the largest pure play mortgage REITs. The fair value of American Capital's investment portfolio is $89.6 billion, 98% of which is fixed rate Agency MBS. American Capital's investment portfolio is said to be prepayment protected. Besides owing HARP and low loan balance securities, the company also possesses low coupon mortgage backed securities.
The company offers a sustainable dividend yield of 15.8%. I have a target price of $40.6. This is an upside of 29% at the stock's current price. The stock trades at a moderate discount of 3% to its book value. A detailed analysis is presented on AGNC in my previous report.
Two Harbors Investment
Two Harbors operates as a hybrid mortgage REIT in the U.S. financial sector with around 84% of the investment portfolio invested in Agency residential mortgage backed securities, while the remaining is invested in non-agency RMBS. The average annualized yield that the company earned on its non-agency RMSB remained flat at 9.6% compared with the linked quarter, however, average annualized yield on Agency RMBS declined from 3.3% in the previous quarter to 3.1% in the third quarter, resulting in a 50 basis points decline in the net interest spread.
The stock offers a dividend yield of 12.85%. The company paid $120 million in dividends the previous year, while it generated $151 million in cash from operations. The stock trades at a moderate discount of 2% to its book value.
PennyMac Mortgage Investment
PennyMac Mortgage invests in distressed mortgage backed securities. Besides, the company purchases originated mortgage for resale or securitization. Therefore, the company has a diverse business model.
I believe the company will benefit from acceleration in prepayments due to QE3, since it owns securities that are purchased at a discount to par. It will also benefit from the availability of more distressed securities as a result of the implementation of Basel III as more and more banks get rid of the ineligible securities.
I have a target price of $28.2. The stock offers a dividend yield of 9.5%. This is an upside of 16.8% at its current price of $24.13. The stock trades at a premium of 19% to its book value. View my report on PennyMac for a detailed analysis on the stock.
Mortgage REITs on average are trading at 15% discount to their estimated fourth-quarter book values. The time period between 2005 - 2007 was the only sustained period when mortgage REITs traded below their respective book values. The favorable situation in the U.S. mortgage market increases my confidence in the stability of the book values, which is why I believe these mortgage REITs will trade at modest premiums to their book values.
In conclusion, I recommend investors to invest in non-agency and hybrid mortgage REITs. Besides, I believe American Capital Agency has the potential to provide capital gains and sustain its elevated dividend yield as it has protected its investment portfolio from prepayments.