I expect compressed net interest spreads and a recovery of the US housing market during 2013. Further, I believe yields will remain low; however, significant additional spread compression is not expected, while the book value will likely remain flat, particularly for Agency mortgage REITs. The Agency MBS sector remains attractive from a long-term perspective. Mortgage spreads have widened 20 basis points over the past 11 weeks, overturning 36% of the QE3 tightening.
Yield Curve Expectations
The Fed's resolve to keep short-term rates low until the US labor market shows signs of improvement and its initiatives including QE3 and Operation Twist to buy long term assets have resulted in a flattened yield curve during 2012. This flat yield curve forced many mortgage REITs to cut their dividends as their spreads were put under pressure. In a report [not publicly available], Credit Suisse reports 1-year and 2-year forward yield curves are both currently pricing in 15 basis points of steepening. This steepening makes incremental investments attractive.
Book Value Expectations
In the fourth quarter, book values are moderately soft driven by some relaxation into the Fed acquisition post QE3. However, MBS strategists at Credit Suisse expect "Agency MBS demand to outstrip supply buy roughly $270 billion in 2013 anchored by Fed purchases and bank demand." Given the strong tailwind coupled with modest expected moves in the long-end of the curve, CS has confidence that the book values will remain stable.
Credit Suisse expects prepayments to remain elevated during the next year, given the persistence of low mortgage rates. It also expects lower coupon MBS should experience a slowdown primarily due to guarantee fee increase (25 basis points expected in 2013). Within lower coupon MBS, the return of traditional convexity advantage of 15-year MBS over 30-year is expected. This would result in 15-year securities being less sensitive to refinance opportunities than 30-year securities for the first time since 2008. Higher coupon MBS are expected to continue to experience higher prepayment speeds from elevated HARP activity.
Prepay outlook remains a major driver of yield expectations. Therefore, I continue to favor Agency mortgage REITs with low prepayment speeds or prepay protected MBS portfolios. American Capital Agency (NASDAQ:AGNC), trading at a moderate discount of 4% to its book value, is my favorite mortgage REIT for 2013. Annaly Capital (NYSE:NLY) is trading at 12% discount to its book value. Among others, Armour Residential (NYSE:ARR), Invesco Capital Mortgage (NYSE:IVR), and Two Harbors (NYSE:TWO) are my favored picks. These mortgage REITs have low prepayment risk and should have more stable cash flows from lower reinvestment needs.
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.