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Agency mortgage REITs were among the best-performing asset allocations since the financial crisis hit the world in 2008 and 2009, but the industry fell on tough times in the second half of 2012. Agency mortgage REITs hold portfolios made up exclusively of residential mortgage backed securities that are insured by federal agencies such as Fannie Mae (OTCQB:FNMA) and Freddie Mac, which come with an agency backing and an implied U.S. government backing.

Most agency mREITs leverage their agency RMBS portfolios in order to multiply the return made on the spread, or margin, between their borrowing costs and the interest paid on the portfolio of agency-backed RMBS that they hold. Most agency mREITs now yield somewhere between 11 percent and 15 percent, which means that these mREITs offer quarterly payouts that are comparable or superior to the annual yield of a 10-year treasury or the S&P 500.

Rising interest rates and accelerating prepayment rates have caused many investors to fear declining spreads and book values within the agency mREIT sector. Mortgage prepayment rates hit their highest levels since before the subprime crash during the second half of 2012, fueled by homeowners continuing to refinance while borrowing remains around historic lows. Mortgage bond investors risk losses when buying debt for more than par or whatever its call rate may be if above par, and these securities will decline in value if interest rates increase.

Agency mREITs and the paper they hold have has significant sensitivity to the recent fiscal cliff matter. Another major concern is the coming debt ceiling debate, which appears poised to occur in February. Agency-backed paper is in many a quasi-treasury, and anything that will change the interest rates or credit rating of U.S. debt will have a similar effect upon agency debt.

While the temporary resolution of the fiscal cliff has occurred, and the outcome appears likely to benefit agency mREITs in the short term, coming fiscal cliff rumblings could cause agency mREITs to slide next month. In the summer of 2011, when the debt ceiling was last at issue, mREITs sustained significant declines, but quickly rebounded after it was resolved.

The largest and best-known agency mREITs are American Capital Agency Corp. (NASDAQ:AGNC) and Annaly Capital Management, Inc. (NYSE:NLY), while the largest mortgage REIT Index ETFs are iShares FTSE NAREIT Mortgage REITs Index ETF (NYSEARCA:REM) and the Market Vectors Mortgage REIT Income ETF (NYSEARCA:MORT). Both ETFs also hold non-agency and commercial mortgage REIT exposure.

Both Annaly and American Capital Agency announced share repurchase plans during Q4 of 2012, which is highly contrary to their usual habit of issuing secondary stock offerings. Due to prepayments and the high dividend payouts that the REIT model necessitates, mortgage REITs usually go to the market and sell additional shares through secondary stock offerings, which is essentially the very opposite of what they are now doing.

This could mean that these agency mREITs believe the market is not appropriately evaluating their books, or that it is overvaluing those available on the open market. These REITs may have also simply come to the conclusion that acquiring more agency paper is too risky and that it was less risky to opportunistically acquire shares in themselves.

Recently, Annaly made a bid to acquire Crexus (NYSE:CXS) a commercial mREIT in which Annaly already holds an over 12 percent interest and which is managed by FIDAC, a wholly owned subsidiary of Annaly. The acquisition would make Annaly no longer an agency-only mREIT. Such maneuvers indicate reduced spreads and dividend rates are likely in 2013, which could cause the companies to significantly decline in value.

Nonetheless, most agency mREITs now trade at a discount to their last reported book values. If these agency mREITs continue to trade below book value, share repurchasing by the company should help strengthen the remaining value per share and counter potential value weakness due to rising prepayments and decreasing spreads.

Given the use of leverage at rates between 5x and 8x the market valuation of these REITs, there is the potential for these companies to sustain losses that are more substantial than that which the underlying agency paper might. This leverage can also be an advantage in certain situations, and any coming weakness due to the debt ceiling debate and its resolution could present a strong buying opportunity within the industry. It turned out to be a good time to acquire agency mREITs after the last debt-ceiling debate, in the summer of 2011, and the current situation appears substantially similar.

Owing to the risks associated with agency mREIT leverage and the potential peaking of treasury valuations, exposure to the asset class should be limited to a reasonable percentage of a portfolio based upon risk profile, time-horizon, income needs and other investments. Additionally, most REIT dividends are taxed as regular income and not at the lower corporate dividend rate, making them substantially better performing investments when held within tax deferred or exempt accounts.

Source: Buy Agency Mortgage REITs On Coming Debt Ceiling Weakness