It's not just high definition TVs and kitchen appliances that are experiencing a post-Memorial Day sale, but the entire Mortgage REIT sector. "Bloody Tuesday' saw the sector down about 4% across the board with some retail favorites like American Capital Agency (AGNC), Western Asset Mortgage Capital (WMC), and ARMOUR Residential REIT (ARR) down as much as 8% before a small late-day bounce. I previously wrote that mREITs, especially long-duration agency mREITs, would be under pressure from rising rates and the fear surrounding such an environment. Rates rose 25 bp. in the week since that article hit. A similar move in rates took the entire 1st quarter and hit book values hard, so you can imagine what went through investors' minds the last few days. And we still have 5 weeks left in the quarter.
Clearly, after the inability of the mREITs (especially the long-duration agency mREITs) to protect Q1 book values when rates rose 25 bp. over the course of the quarter, investors fear that with rates having risen a full 50 bp. in 1 month that the mREITs might have experienced a second shock to book value. It is not the rise in rates itself that is the problem, but the speed of the move. As Gary Kain of AGNC has said, there is no hedging volatility and rapid rate rises in such a compressed time frame.
The fall in prices in the mREITs is not unexpected. Even if book values are hit less than the drop in price would indicate, I have long expected an initial panic once rates rose. I expected that to happen whether the rise in rates occurred at the short-end with Fed Funds (bad) or the long-end for the 10-year and MBS yields (GOOD). Check out the compression in book values below (data as of May 27 from Morgan Stanley):
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If falling rates since 2010 were all good for the mREITs, then why have agency mREIT P/B values trended lower the last 2 years? Because eventually the compression in yields from falling reinvestment yields was not beneficial to dividends. Note that hybrid mREITs have maintained better P/B valuations:
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If the playbook were 1999 or 2005, then a rising Fed Funds rate would lead to fears that the Fed would go further and farther than just a few 25 bp. hikes, raising the cost of carry, flattening the yield curve, and leading to a decimation of dividends. Dividends were cut 75-90% in previous bear markets. Every time the Fed has begun a tightening campaign, it has gone on longer and further than bond experts have predicted. So even if the Fed were to stop at 1% or 1.5% on Fed Funds, until it actually occurred and there was talk of rate cuts the market would assume that 1% would become 2% would become 3% ... etc., etc., etc. mREITs would trade like death in that environment as long rates either go up much less than short rates or even go down. In either event, interest spreads for investment get decimated, dividends dry up, and mREIT book values and stock prices get taken to the woodshed.
But the last 2+ years have been different. Spreads have been under assault, not from short rates rising but from long rates falling. It started with the 2011 'risk-off' market which collapsed yields from 3.50% on the 10-year Treasury to 1.75% in 6 months. It continued with another decline in yields in early-2012 that did not stop until ECB President Mario Draghi took the pressure off Euro-troubled countries. Finally, the last stage of yield compression was QE3 which involved a direct frontal assault by the Fed on mortgage spreads through the monthly purchase of nearly the entire supply of MBS paper, $85 billion per month. As a result, investment yields and dividends have been under pressure for several quarters going back to early-2011 for the mREITs:
You can see the end of one yield compression in July 2012 (Draghi's speech) and another one in October 2012 (once QE3 was fully discounted).
A longer-term view on 15-year MBS paper against overnight repo borrowing costs shows that QE1 in 2008-09 was associated with spreads of about 350 bp. and QE2 in 2010 produced spreads of 250-350 bp. But the combination of "risk-off" and QE3 took yields to levels that caused a flurry of dividend reductions as spreads fell as low as 75-125 bp. Only recently has the range started to move up:
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You can see that at the nadir, the spreads for MBS investing for the mREITs was not much above the pre-2008 levels which were associated with a Fed Funds rate of 5.25% through most of 2007. If spreads can move north of 300 bp. on the 30-year MBS and 200 bp. on the 15-year MBS, dividend pressure is likely kaput. mREITs have various earning computations - GAAP income, core income, taxable income - and rapidly rising rates could pressure book value and impair dividend capacity for those mREITs without undistributed taxable income (like AGNC). But the important thing is that future spread income will cover the current dividends, once reinvestment and book value levels normalize.
Look at the dividend yields in 2005-06: they fell to UNDER 3%. After stabilizing at a 12-14% yield in 2003-04 when Alan Greenspan cut the Fed Funds rate to 1%, dividend yields got sliced 75%. That is far worse than the recent yield compression leading to a 25-30% cut in agency mREIT dividend yields since the 2011 peak. With lower leverage and a lower P/B starting valuation compared to the earlier period, we should not experience either the absolute price declines or the book value hits.
Let's recap: rising rates are historically bad for mREITs because they have always been associated with rising short-rates and slower-rising long-rates equating to a flatter yield curve and narrower spreads (sometimes negative). In the current environment, we are only talking about ending QE3 by tapering it - leading to rising long-rates - and nothing at all regarding a rising Fed Funds rate or other short-rates (LIBOR, 2-year Treasuries). Thus, we are talking about a wider net interest spread down the road and ultimately higher investment yields and stable/rising dividend yields.
I discussed mREIT Math in an earlier article on the mREITs. ROEs for agency mREITs are much improved and probably higher by 150-200 bp. than a few weeks ago. Book values are lower, but when you multiply the higher ROEs by the lower book values, you still get dividend yield capacity close to the current level, perhaps a bit above. The important thing is that while the price and book value declines are painful, this pain is DIFFERENT than in the past. The fundamentals for the mREITs are actually improving which was NOT the case in the previous mREIT bear cycles.
Let's look at what might be some positive near-term catalysts:
- 10-year and MBS yields stabilizing, either on U.S. or global economic data (China, Japan) showing slowing growth.
- Realization that the SEC and FSOC regulatory attacks on mREITs are either non-existent or will result in giving them very wide latitude in running their business models.
- Dividend announcements for the sector begin in mid-June.
- Earnings data in July may indicate that the mREITs took the Q1 rate spike seriously and hedged their portfolios for rising rates.
- Current dividend yields are higher as prices have fallen: agency mREITs average dividend yield is up to 12.5% from 11% in mid-April. Hybrid mREITs average yield is 12.7%, up from just under 11% in mid-March.
- Realization by mREIT investors that "this time it IS different" and that rising long-yields (as long as the entire 'risk-off' move is not repealed) are different than rising short-yields and will eventually help dividend payment capacity for the sector.
There is nothing worse than seeing the markets up over 1% like yesterday and seeing virtually every equity and bond position in the red because of the spike in yields (trust me, 33 out of 34 positions I had were red). But mREITs are essentially leveraged bond funds and bonds will eventually find a floor consistent with value. If you think rates are heading straight to 2.50% or even 3.00% -- or higher -- then by all means trim positions. But if you have plenty of cash or are underweight the sector, you can definitely nibble at the best-of-breed names at current levels. Use wide scales to purchase additional shares - maybe add another 2-3% in mREITs for every 5% drop in price - so you do not exhaust your cash levels too quickly.
Hybrid mREITs like Two Harbors (TWO) and American Capital Mortgage (MTGE) are much closer to book value than a few weeks earlier. TWO has held up better, but MTGE has Gary Kain and the folks from American Capital Agency manning the turrets. I continue to think AGNC has value at or under book and would definitely buy if I had no position or add some at these levels, subject to cash levels. CYS Investments (CYS) is at a 10% discount to book value and with a focus on 15-year paper probably is not as exposed to rising rates as the AGNC-WMC-ARR troika. As a reminder, I gave my best-to-worst ranking for mREIT purchases earlier and stand by the agency and hybrid mREIT rankings.
It's not a question of loading up on mREITs or exiting entirely. You can play the sector in smaller size, with short-duration mREITs, and with hybrid mREITs. Right now, the sector has the wind in its face. But that same wind can lift a kite - or dividend yields - if you know how to properly position yourself.