There is increasing angst among Mortgage REIT investors in recent months. The sector experienced hyper-volatility during the recent market swoon with the stocks losing twice as much as the S&P 500. Many new investors in the stocks were shocked as a defensive sector with high dividend yields saw a year's worth of dividends wiped out in a few weeks. The market once again dished out a lesson that there is no such thing as a Free Lunch, and that ALL investments have certain risks in addition to their advantages.
Despite the increased volatility and the downward trend of dividends, I believe the Agency MREITs and their sister Hybrid MREITs still offer a good value proposition for conservative investors. Before we design a strategy for investors, let's look at the reasons why the sector has had a lot of investors reaching for the Alka-Seltzer lately.
Here are the major reasons for the recent weakness and the continued fears going forward:
- Refinancing & Prepayment Risk: More homeowners are taking advantage of lower mortgage rates and refinancing, either on their own or through government-sponsored programs like HARP 2.0, which many banks are implementing and ramping up capacity. With MREIT investment portfolios chock-full-of premium mortgage backed securities (MBS), these prepayments reduce yields and ultimately dividends.
- Headline Risks: The re-election of President Obama has spiked fears that beyond HARP there might be some mass refinancing option involving principal forgiveness, exacerbating the prepayment conundrum. A corollary risk involves the replacement of FHA Director Ed DeMarco, an opponent of principal forgiveness and other radical refinancing options favored by leftist housing advocates. Even if nothing actaully happens legislatively or with DeMarco, the headline risks remain which would negatively impact the stocks.
- Reinvestment Risk: With Ben Bernanke and the Federal Reserve playing the part of the Crazy Uncle With Too Much Money, we have an irrational buyer of MBS who is reducing yields on MBS for portfolio investment. This also simultaneously increases prepayment risks by keeping rates artificially low.
I believe that while all of these risks will remain for a few more months, to a certain extent they are 'in the stocks' though further share weakness cannot be ruled out. Prepayments have been rising but not accelerating to higher levels, especially for those Agency MREITs which specialize in prepayment-protected portfolios like American Capital Agency (AGNC), CYS Investments (CYS), ARMOUR Residential REIT (ARR), and Western Asset Mortgage (WMC). Headline risk is somewhat contained for the moment in that it would poison working relations with congressional Republicans. Plus, any principal forgiveness would basically recreate the early-2010 delinquent mortgage removal, something that was navigable for the MREITs. Actual losses are borne by the GSEs, not the Agency MREITs. Finally, while the Fed is hurting reinvestment yields several of the companies are still able to achieve low double-digit ROEs by minimizing prepayments and by trading in-and-out of cheap and expensive sectors. The wind is not at the Agency MREITs backs, but it's not quite 2005-06 when the Fed was raising interest rates 17 times and decimating their earnings and dividends.
It is not a fait accompli that rates must move lower from here even with the Fed buying the majority of the MBS supply each month: recall that in the mid-2000's Alan Greenspan was frustrated that mortgage and long-rates remained low despite the Fed tightening rates (mostly because of Chinese and other Central Bank buying). A 30-40 bp. rise in the 10-year Treasury (not a huge move compared to where we have been in recent years) and commensurate rise in mortgage rates would greatly improve investment yields and also slow prepayments and refinancings in their track.
Here are my 5 reasons for sticking with some exposure in Agency MREITs:
1. Dividend Yields: Despite cuts in dividend yields, unless prepayments accelerate or a policy shock or U.S./European downdraft reduces bond yields further, at current levels the sector dividend yield is still above the 10% Mendoza Line. While a few stocks have recently fallen below that dividend level, others remain comfortably above it. Take a look at this chart from Morgan Stanley and SNL Financial:
While the sector had fewer publicly-traded stocks during the Fed tightening cycle of 2004-06, the Agency MREITs fell about 50% in price in response to the 75% collapse in dividend yields to the low single-digits. That is why I am not super bearish: although dividends are getting cut despite no Fed rate hikes, I do not see dividends getting cut another 50-60% from current levels. If the dividend yields are not going to approach the 2005-06 lows, then the stocks should not trade at the depressed price-to-book levels we saw back then.
2. Book Values: As you can see from the chart below, the Mortgage REITs were at substantial premiums to book value prior to their last true bear market in 2004. The sector average P/B was close to 140%. A few months ago, the sector traded at a P/B of about 105-110%. Today, the stocks are at about 90-95% P/B. The Agency MREITs have largely de-risked and are actually at a discount to liquidation value, hence, there should be less pressure on the stocks.
3. Lower Leverage: Mortgage REITs used much higher leverage last decade, with the sector average actually above 10:1. The sector is much more conservative today and sector leverage is closer to 7:1 today for the Agency MBS portfolios. Less leverage merits less of a premium to book value because earnings and dividends are lower but it also means less risk going forward.
4. Defensive Attributes Remain: The Agency MREITs remain credit-risk free, which could come back into vogue should the U.S. or European economies find trouble in 2013. The European Union worked with Treasury Secretary Tim Geithner to minimize financial market volatility in the months leading up to the November Election. With the election out of the way, and with banking and sovereign problems beginning to resurface again, credit problems could resume, making the Agency MREITs a defensive bastion even if rates initially go lower as part of a 'risk off' trade.
5. Savvy Buyers: Insiders at many of the Agency MREITs have purchased decent blocks of stock in recent months, and the companies themselves have announced share repurchases of 5-15%. Most of the companies would probably get aggressive in buying their shares at 85% of book value, so that should provide a decent floor on price.
While I am more cautious on the Agency MREIT sector since mid-September, I still believe they have a place in investor's portfolios. The key is to use a prudent and balanced approach that also takes into account your other assets as part of a risk-mitigation strategy. With bond and money market fund yields much lower than in previous MREIT bear markets in 2000 or 2005 and with the overall stock market not providing the returns it did 7 years ago, I believe the Agency MREITs will continue to offer quasi-defensive attributes and decent dividend yields relative to other equity and fixed-income alternatives.
Here are 5 ways to incorporate MREITs prudently and safely into your portfolio:
- Think Small: The huge positions of the past when the sector had the wind at their backs should be cut back, subject to your risk tolerance and overall portfolio composition. If you had 40% of your portfolio in the MREITs in recent years, consider 20-25% today. If you had 25% in MREITs, consider 15% going forward. If you are a newcomer to the sector, start small and be prepared to buy if the stocks go lower because of headline risks.
- Asset Allocation: Agency MREITs yields are so high you can still have healthy allocations to cash and low-yielding, conservative bond funds and still have a healthy yield. The Retiree Income Portfolio I supervise (PortfolioChannel.com) has achieved the 6% targeted yield for conservative retirees despite a 20% cash position and a 30% conservative bond position. Since we are in football season, remember that sometimes you have to take what the defense - or in this case, the markets - will let you, and not stretch for yield. Live to fight another day and become more aggressive in the future when the odds are more in your favor.
- The Basket Approach: I believe that the MREIT sector is the quintessential niche sector where you MUST have multiple stocks to avoid specific risk in any 1 or 2 stocks. Try and have at least 4-5 names and spread your risks. One stock should not be 50% of your entire Agency MREIT position. Be smart, not greedy.
- Best Of Breed: Don't be afraid to take laggards in the sector or lower-yielders, as they may offer future defensive outperformance. But emphasize the best-of-breed, stocks like American Capital Agency and CYS Investments that have been deft in recent quarters in minimizing prepayments and maximizing interest income and shareholder dividends. If you must invest in laggards like Annaly Capital Management (NLY) or Anworth Asset Mortgage (ANH), invest in them as part of a diversified basket and do not bet the farm that they will reverse and outperform anytime soon.
- Hybrid MREITs: I have always had Hybrid MREITs as part of my MREIT basket approach, but I believe it is OK to increase the allocation since non-GSE debt should continue to outperform agency GSE debt unless we double-dip back into recession. Normally my Agency/Hybrid allocation has been 3:1 or higher but I believe a higher allocation to Hybrid MREITs is appropriate today. Stick with the Hybrid MREITs with modest positions in non-GSE debt and/or more conservative approaches to credit risk. My favorites are Dynex Capital (DX), AG Mortgage Investment (MITT), MFA Investments (MFA), and Apollo Residential Mortgage (AMTG).
Many of the dividend and income favorites that retail investors have flocked to - closed-end funds, MLPs, BDCs - have their own specific or company risks. A stock market closer to S&P 1400 also has more downside risk than when it was trading closer to S&P 1250 so investing in traditional S&P 500 dividend stocks is not the layup alternative to the MREITs it was in 2004. With no safe 'hiding spots' readily available, I believe the prudent choice is a balanced approach to the Mortgage REIT sector despite the headwinds. Check your exposure to the sector relative to your other holdings, make sure you have a basket of the names, add a few Hybrid MREITs, and then cross your fingers and hope that Washington, DC gets their act together.
In the meantime, a yield of just under 1% a month covers a multitude of problems.