"This is the year you should start thinking about reducing exposure to the mortgage REITs. There's a tremendous amount of price risk and the Fed has got its fingers all over everything." - Wall Street sell-side analyst
Mortgage REITs have suffered some weakness in recent weeks, with the sector falling about 5% from early-April peaks and some popular stocks like American Capital Agency (NASDAQ:AGNC) and Western Asset Mortgage Capital (NYSE:WMC) falling 10-12% within a few trading days in May. This while the S&P 500 has been screaming higher. The sector stabilized at the end of last week but investors are concerned. Several formerly bullish analysts like the one quoted above urged caution.
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The proximate cause for the sell-off was the sudden rise in bond yields, specifically the 10-year Treasury jumping 30 bp. in a little more than a week to 1.95%. An earlier gradual rise in the 10-year during Q1 to 2.05% caused some of the agency MREITs to experience large hits to book value, notably AGNC when it released Q1 results a few weeks ago and WMC last week. Rates stabilized and began to fall in April and investors assumed that the hits to book value were reversing in the second quarter. Then the 10-year Treasury spiked again earlier this month at the same time that the high-profile MREIT 1st quarter earnings releases came out. The earlier rise in rates KO'd book value for a number of previously bullet-proof agency MREITs and the fear was that the May spike - and further increases - could do as much or more damage again. MREIT investors panicked.
Let's put both recent bumps in yields in perspective: the 10-year Treasury was 2.25% in October 2011. What scared the market was not the move higher - indeed, for some time MREIT investors have been hoping for higher rates - but the speed of the move. It is nearly impossible to hedge rapid rate moves of that order and the fear was that continued rapid-rises in interest rates would have the deleterious effect of knocking down book value very quickly while the benefits of slowing prepayments and rising investment yields took time to materialize. In other words, MREITs would have several months of eating broccoli and Brussels sprouts before they could enjoy their ice cream.
This seems like one of those "hand-holding times" where folks need to remember why they own the sector, why they own particular MREITs, and what they should own. The sector had a rocky Q1 and there are more problems ahead if rates continue to rise or if the Fed starts to talk about tapering off QE3, let alone actually slowing down MBS purchases. But actual MBS spreads have benefited from rising rates in recent months from when QE3 started back in September. Check out the spreads today compared to a few quarters back when QE3 first started:
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You should immediately note that all of the big losers in Q1 book value - AGNC, WMC, and ARMOUR Residential REIT (NYSE:ARR) -- have the same strategy: high leverage + 30-year mortgage paper. In a rising rate environment, this is precisely what you do not want to own. Notice how the hybrid ARM agency MREITs - CMO & HTS - were flat for the quarter in book value. Even perennial laggard ANH only got nicked in Q1.
Clearly, if you invest in the higher-yielding agency MREITs, you are taking more risk (memo to self: higher yield = higher risk !). If you want the yield of the more aggressive MREITs, you are going to experience higher volatility in a rising rate environment OR you must hope that rates stabilize or head a bit lower from here. Don't want that volatility ? Then either spread the risks or concentrate more resources in short-duration, hybrid ARM-focused MREITs like CMO, HTS, and even ANH.
Agency and hybrid MREIT book value estimates, trailing and forward yields, and P/B levels can be glanced at here:
If rates are headed higher, you can also invest in hybrid MREITs. Hybrids will do better in a rising rate environment because presumably the rise in rates will reflect a strengthening economy which benefits credit-sensitive paper. Check out the performance YTD and over the last 12 months for a group of agency and hybrid MREITs:
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A picture is worth a thousand words, so here are 1,000 words on why hybrid MREITs have done so well the last few quarters:
Not sure of what whether to buy agency or hybrid MREITs? Not sure which ones to buy in each group ? No problem - buy 'em all ! I have recommended the "basket approach" numerous times on Seeking Alpha and I believe you can diversify specific risk by buying 4-5 agency and hybrid MREITs each. You are buying the sector for the dividends, so why not eliminate the risk of price declines by making sure you pretty much grab the sector yield ? If it works for a portfolio of stocks, it will work for a portfolio of MREITs.
It is important to understand what your MREIT owns if you are not going to employ a basket approach and spread your risks. While some parts of the MREITs such as hedges and swap ratios are beyond most investor's comprehension and analysis, there are other variables you can check to see if there is dividend or price risk ahead. Check out MREIT Math (below). You start with an initial Asset Yield and after your Cost Of Funds (not shown), you arrive at Net Spread. That Net Spread is multiplied by the Leverage Ratio and added to the initial Asset Yield from which the OPEX costs are subtracted. The net result is the return on equity (ROE) which is then multiplied by your book value to give you the MREIT's true portfolio earnings potential. In the examples below, CYS easily covers its current dividend, AGNC is a bit short, and Annaly Capital (NYSE:NLY) is woefully short.
No two MREITs have the same portfolio composition, cost of funds, hedging ratio, leverage, or operating expenses but the basic mechanics are the same. It starts with the decision to invest short or long and what specific MBS paper to purchase (generic or TBA forwards are cheaper; prepayment protected is more expensive). So if you think rates are going up or down, you can shift your portfolio accordingly towards the right MREITs.
Similar to MREIT Math, we can look at what various MBS paper will yield for different coupons, keeping leverage constant. Note the ROE for a low-coupon 3% MBS versus a high-coupon 5% MBS:
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Clearly, if two MREITs own different paper - one low-coupon and the other high-coupon - they will earn different ROEs and have much different earnings and dividend capacity. But the low-coupon bonds will suffer much sharper price drops if rates rise as they did recently (this is the paper that AGNC, ARR, and WMC focused on). Again: the higher-yielding paper comes with higher-risk.
In my recent portfolio commentary for my Retiree Income Portfolio, I gave my current ranking order for the Agency MREITs: American Capital Agency, Capstead Mortgage (NYSE:CMO), Hatteras Financial (NYSE:HTS), CYS Investments (NYSE:CYS), Western Asset Mortgage , Anworth Asset Mortgage (NYSE:ANH) and finally ARMOUR Residential .
For the hybrid MREITs, my ranking for 2013 at this point in time is as follows: Two Harbors (NYSE:TWO), MFA Financial (NYSE:MFA), Dynex Capital (NYSE:DX), AG Mortgage Investment (NYSE:MITT), Apollo Residential Mortgage (NYSE:AMTG), Javelin Mortgage (NYSE:JMI), Chimera Mortgage (NYSE:CIM) and finally, NLY, which just added non-agency paper (I believe CIM will eventually be merged into NLY, for those of you who own CIM). Those are my current rankings based on recent price, book value, management expertise, dividend and book value stability over recent quarters, and price volatility.
So there are 3 things you can do to minimize price volatility in the MREIT sector if you are convinced that the bias is to HIGHER interest rates:
(1) The Basket Approach: Buying a basket insures that you have diversified your risks. Simply buy 4-5 agency AND hybrid MREITs each or some numbers close to those. In my personally managed accounts I currently own 10 MREITs, equally split in numbers between the two types of MREIT. The dollar amount is slightly in favor of the Hybrids after several years of being mostly 2:1 or 3:1 in favor of agency MREITs.
(2) Focus on short-duration and ARM-focused MREITs: Their shorter-duration focus will do well in a rising rate environment. CMO and HTS and even ANH are much more defensive than longer-duration agency MREITs using high leverage.
(3) Focus on Hybrid MREITs: they have allocations from 10-40% in credit-sensitive bonds. These have higher coupons, lower durations, lower leverage, and a direct correlation to a strengthening economy. They do much better than agency MREITs in a rising rate environment. (Note: hybrid ARMs should not be confused with hybrid MREITs. A hybrid ARM refers to the adjustable and fixed rate nature of the mortgage. Hybrid MREITs refers to those vehicles which hold both agency and non-agency MBS). Also, pay attention to the allocation to non-agency and the leverage. In the past it was not unusual to have hybrid MREITs that had only 10-15% of their total portfolio in non-agencies. The percentage may seem low, but it can represent 30-40% of the equity capital at risk.
Remember, even if you minimize one type of risk your MREIT may offset it elsewhere. For instance, CMO has short-duration MBS but a bit higher leverage than most others. At the current combination of low-duration but moderately-high leverage it is low-risk compared to the longer-duration agency MREITs. But years ago CMO ran leverage closer to 11-to-1. When it did, the stock price lost almost 50% during the Bear Stearns fiasco of 2008. Hybrid MREITs can lower their leverage by shifting money from agency MBS (usually leveraged 7-9x) to non-agency (usually leveraged 2-4x). If you want to concentrate your MREIT bets, know what you own.
With all the moving parts that are beyond most MREIT investors ability to properly measure and sometimes even understand - swaps and swaptions, hedge ratios, active vs. passive portfolio management, repo maturity lengths - it is important to focus on the big variables that will most determine your MREIT's dividend yield, performance, and volatility:
- Agency vs. non-agency split
- Short vs. long duration MBS portfolio
- Leverage ratio
If you keep an eye on those variables and diversify your holdings, problem like those earlier this month should be smoothed out. Stay up-to-date with the Seeking Alpha contributors who cover the sector regularly, and consider checking out Valueforum for additional buy-side and sell-side commentary. And that sector-rich 12% dividend yield tends to cover a lot of problems over time.
Disclosure: I am long CYS, ARR. 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.