Investor Confusion About Agency mREITs and Mortgage Rates
As I read articles discussing whether the mortgage REITs like Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) can sustain their dividends in the current interest rate environment, I believe that a difference needs to be highlighted between mortgage rates and mortgage-backed securities (MBS) yields.
Investors must be very aware that the agency mREIT companies do not buy mortgages, they buy mortgage-backed securities and there is a very big difference. Agency MBS are marketable securities that draw principal and interest payments from a pool of similar mortgages. The yields on MBS are different from mortgage rates for several reasons.
MBS Rates vs Mortgage Rates
First, current rates on 30-year mortgages are about 3.4% and on 15-year loans, 2.75%. The mortgage servicing company gets 25 basis points of the rate, so the net yield in a mortgage pool will be 3.15% for 30-year loans and 2.5% for 15-year loans. As a result, late-model agency MBS will have coupon rates of 3.0% and 2.5% respectively.
The bond markets determine the pricing and net yields for MBS bonds. This is where the yield an agency mREIT can earn veers away even further from mortgage rates. Here is a list of recent prices and the current yield - coupon divided by price - for some agency MBS.
30-year, Fannie Mae (OTCQB:FNMA), 3.0% coupon. Price: 104-22. Current yield: 2.87%
30-year, FNMA, 3.5% coupon. Price: 106-16. Current yield: 3.29%
30-year FNMA, 4.0%, Price: 106-01, Current yield: 3.77%
However, the current yield does not account for the loss of the 4 to 6 cents per dollar when principal is paid back on the mortgage loans in an MBS pool. The Wall Street Journal lists an average maturity for the 4% FNMA bond at 2.8 years, resulting in a yield-to-maturity of just 1.23%. The WSJ MBS rates page only lists higher coupon rate bonds and the average maturity on these bonds is very short, resulting in yields-to-maturity ranging from 1% to 2% for 30-year MBS and 0.8% to 1.3% for the 15-year agency MBS.
I could not find expected maturity and YTM information on the lower coupon MBS, but you can see from the premium prices, these bonds will have a yield to maturity somewhere well below 3%, significantly less than the 3.4% current 30-year mortgage rate.
Agency mREIT Interest Earnings
For the 2012 third quarter, Annaly Capital reported an annualized yield on its MBS portfolio of 2.54% and an annualized interest spread of 1.02%. American Capital Agency reported an asset yield of 2.55% and net spread of 1.42%. Both companies experienced about a 50 basis points (0.50%) reduction in the spreads over the recent 12 month period.
Making some assumptions from current and historic MBS prices, including an expectation that the lower coupon MBS have average maturities in the 5-7 year range and the expected yield to maturity is 60 to 80 bp over comparable Treasuries, current MBS yields-to-maturity rates probably top out at about 2%. Which means there is the potential for another 50 bp squeeze on the agency mREIT spread.
Taking 50 basis points out of a 2% spread is a one-quarter reduction. The same reduction coming out of a 100 bp spread is a 50% drop in net income. The agency mREITs have reached the point where even small declines in interest earnings will take a much larger piece of the net interest income.
The main point of this article is that investors should take little comfort in 3.5% mortgage rate. The prices and yields of agency MBS continue to be squeezed by the market hunger for these bonds and the Fed's QE3 massive buying of agency MBS. Currently, 3.5% mortgages probably produces sub-2% MBS yields.
The second point is that net interest income and the resulting dividend rates could easily end up at half the rates paid in early and mid-2012. The mREIT companies have made it clear that business is tough by switching to share buybacks, such as the just announced, very large buyback by American Capital Ltd. (NASDAQ:ACAS) - a much different story than when these companies were selling new shares every quarter to expand their portfolios.