Agency mortgage REITs are entities that invest in a portfolio of mortgage backed securities (MBS) that are directly or indirectly backed by the government, financed with short-term repos against these securities. Although the credit risk for agency mREITs is minimal, they are highly exposed to interest rate risk; therefore the Fed's monetary policy actions are of huge significance to this sector. After a not-so-good first quarter for the sector, many investors are worried about what will happen when the Fed finally starts to taper off its QE program. In this article, I will attempt to explain how the end of QE will impact the agency mREITs.
In order to understand how the end of QE will affect agency mREITS, first we would have to look at these two questions:
- How would the Fed's tapering off of QE impact the interest rates and the yield curve?
- How would the change in interest rates affect various mREITS individually?
Impact On The Yield Curve
The Fed is currently buying $40 billion worth agency mortgage-backed securities and $45 billion worth long-term Treasury bonds per month for a combined $85 billion stimulus per month. This stimulus affects the long end of the yield curve and is intended to bring down long-term interest rates in order to spur a housing recovery. This has had the impact of bringing long term interest rates to all-time lows. When the Fed starts to taper off its bond buying, the gap would have to be filled by private sector investors, and the private sector investors would probably demand higher interest rates on the bonds than the artificially low yields that the Fed has been buying at. This would push the long term interest rates higher.
On the short end of the yield curve, things will remain relatively stable since the Fed has promised that its Federal Funds Target Rate will remain between zero and 0.25% until the unemployment rate remains above 6.5% and inflation remains under 2.5%. Thus short-term interest rates will continue to remain extremely low.
With the long-term interest rates rising and short-term interest rates remaining close to zero, the yield curve is expected to steepen once the Fed starts to cut down on QE. In fact, this could happen even before the Fed starts to cut down on its bond buying if the market starts to believe that the Fed is about to taper off the QE program.
It is very important for investors to understand that the steepening of the yield curve has already started. The chart above shows the ratio of the iShares Barclays 1-3 Year Treasury Bond Fund (SHY) to iShares Barclays 20+ Year Treasury Bond Fund (TLT) which can be used as a proxy for changes in the yield curve. Remember, if the SHY/TLT ratio goes up, it means that the short term bonds are outperforming the long term bonds, implying that the yields on the long term bonds are going up (down) more (less) than the yields on the short term bonds. Therefore a rise in the ratio shows that the yield curve is steepening.
You can see from the chart above that the ratio crept higher during the first quarter when a series of strong data points lead to speculation that the Fed could cut down on QE earlier than expected. The ratio went down again after a few soft data points, but started to move higher again since the start of May.
To understand how a steepening yield curve would affect agency mREITs, we would again have to look at two questions:
- How would a steepening yield curve impact the book values of the mREITS?
- How would a steepening yield curve affect the net interest margins for mREITs?
Impact On Book Values
As you know, bond prices are inversely related to bond yields. As the yield curve steepens and interest rates rise the price of the mortgage back securities held by the mREITS would go down. The extent to which the change in the bond's yield affects a bond's price is measured by its duration. Those mREITS that have a large proportion of their investments in fixed rate long term bonds like American Capital Agency (AGNC) and ARMOUR Residential (ARR) would get hit the most. One the other hand, mREITS that invest in short duration or adjustable rate mortgages (ARMs) like Capstead Mortgage Corp. (CMO) and Hatteras Financial Corp. (HTS) would be least affected.
Impact On Interest Spreads
As the yield curve steepens, the spread between long term mortgage rates in which mREITS invest and short term repo rates which mREITs pay to finance their investments would increase. This is would a big positive for the mREIT sector because generating a good spread is the core business for mREITs. Another positive affect of rising interest rates would be a fall in prepayments. However, one negative from the end of QE is that the volatility in mortgage bond yields will rise from the current all-time lows once there is no Fed to buy mortgage securities on a consistent basis. Not only will this make hedging the interest rate exposure more expensive, but it would also increase the difficulties in devising effective hedging strategies, and thus result in more volatile book values.
Ultimately, investors want to know how the positive impact on net interest spreads and negative impact on book values would combine to affect the price and dividends of these agency mREIT stocks. Fortunately, we already got a glimpse of how the market would react to a cut in QE from mREIT stocks' Q1 results as rumors of an early end to QE resulted in a spike up in mortgage rates and a slight steepening of the yield curve. After the Q1 results, investors paid more attention to the steep decline in book values than the expected increases in interest margins.
Here's a look at how I expect things to go down with individual agency mREITS:
American Capital Agency
American Capital Agency invests mostly in longer duration fixed rate HARP or lower loan balance securities that have a relatively lower prepayment risk; in fact, American Capital has one of the lowest Conditional Prepayment Rates (CPR) in the sector. Although this strategy works well in a low interest rate environment when long-duration book values rise and there is a high prepayment risk, I'm not quite confident about this strategy in a rising interest rate environment as book value will fall and prepayments will naturally fall. This was demonstrated in American Capital's Q1 results which showed that its book value dropped 8.6% due to a slight rise in interest rates. Sure, eventually American Capital will get the benefit of an improved interest rate spread but that would be after the mREIT takes losses on its current investments. On the other hand, if the Fed expand the QE or maintains it for a longer period than expected, American Capital Agency would benefit.
Similar to American Capital Agency, ARMOUR Residential's existing portfolio is composed mostly of fixed rate 30-Year securities. ARMOUR Residential also invests in 20Y, 15Y and Hybrid ARM securities, and its CPR is slightly higher than American Capital's at 15.7%. However, ARMOUR's relatively high leverage ratio at 9.17 during Q1 as compared to American Capital's 6.5 meant that its book value also declined by a hefty 8%. Due to these portfolio characteristics, I would also expect ARMOUR Residential to underperform if the Fed tapers off the QE earlier than expected.
Annaly Capital Management
Annaly Capital Management (NLY) invests most of its capital in fixed rate vintage residential MBS securities. Like ARNOUR and American Capital, Annaly's book value per share also declined 4.2% during the quarter. For reasons similar to American Capital and ARMOUR Residential, I would expect Annaly to take a hit when the Fed starts to taper off the QE.
Hatteras Financial Corp
Hatteras Financial follows a rather conservative investment strategy and invests mostly in short duration hybrid ARMs with a view to preserve book value in times of interest rate volatility. This can be seen in Hatteras' Q1 results which show that its book value remained virtually the same despite the short spike in interest rates. It is also relatively easier to effectively hedge hybrid ARMs from rising interest rates, and that is why I expect Hatteras Financial to outperform during periods of uncertainty when the Fed decides to cut down on QE. However, Hatteras would not be able to reap the full benefits of widening interest rate spread as a result of a steepening yield curve.
Capstead Mortgage Corporation
Capstead is considered to be the most defensive name in the mREITs sector as it invests almost exclusively in short duration ARM agency securities; I expect that Capstead's book value would be the least affected due to changes in the Fed's monetary policy. Indeed, in Q1 when many agency mREITS reported sharp declines, Capstead's book value per share witnessed a slight increase from $13.58 to $13.60, while at the same time its financing spread on residential mortgage investments rose two basis points sequentially to 1.15%. For reasons similar to those mentioned above for Hatteras, I would expect Capstead to outperform when the Fed starts to taper off the QE.
As an investor, it is important to think about how future policy changes from the Fed would affect your investments. When Fed starts to cut down on its QE program, the yield curve would steepen. This would be good for mREITs' interest rate spreads but bad for their book values. For agency mREITs that invest in longer duration fixed rate securities, ideally you would expect their stock price to remain the same due to as the rise in price-to-book ratio due to the expected future increases in interest rate spreads and a decrease in prepayments should off-set the decline in book values. However, I don't think that this will happen. I believe that in the short term, there would be a huge uncertainty about the effectiveness of their hedging strategies in preventing book value declines. In such an environment, I would expect Hatteras, and especially Capstead to outperform in the agency mREITs sector. After fixed rate mREITs like American Capital Agency take some losses on their book value and replace their existing investments with new, high yield securities, I would expect them to outperform their more conservative peers in the long term.
Thus when I believe that the time has come that the Fed would taper off the QE, I would be replacing some of my positions in American Capital and Annaly Capital with Hatteras and Capstead in order to preserve my capital. Later on when the situation becomes clearer, I would get back into American Capital and Annaly, hopefully at a lower price.
Between American Capital and Annaly, I would prefer to hold more of Annaly in a rising interest rate environment because unlike American Capital, Annaly has been here for a long time and has demonstrated its performance throughout various interest rate environments.