Anyone involved in the mortgage REIT space has had a tough time over the last few weeks as the following chart shows:
Of the larger players in the space - Annaly Capital Management (NLY), American Capital Agency (AGNC), Armour Residential (ARR), Two Harbors Investment (TWO), Hatteras Financial (HTS) and MFA Financial (MFA) -- only MFA and Two Harbors have remained in positive territory, the others have fallen, in some cases (AGNC and ARR) rather significantly.
Given the drop in price, the yields available in the mREIT space have increased:
As tempting as it may be in the current interest rate environment to jump in now and consider these "value" investments, an investor should first assess the current environment and form an outlook for the sector and the valuation drivers.
The two primary drivers of the sector's valuation currently are the possible change in the Federal Reserve's bond purchases and the general direction of interest rates.
The Fed, through its massive bond buying program, has created a near scarcity of mortgages, keeping prices high by changing the supply factor. Should the Fed start to "taper" its purchases of mortgage bonds, the supply will increase, spreads will widen and prices will fall. This would, essentially, remove the "floor" under the mortgage market. While on a go forward basis, this would help increase the net interest margin, the existing portfolio (the bigger factor) would be negatively affected and therefore cause a reduction in the NAV.
The second factor is the overall direction in interest rates. Using the ten year Treasury as a proxy for interest rates (due to its use in determining mortgage rates) we see the following rate history over the last year:
The ten year Treasury rate has been relatively range bound over the last year in a range of approximately 1.50% to 2.00%. A longer look including inflation and payrolls shows us the following:
From the above chart, we can see that the ten year note should have a positive spread over inflation and follows the directionality of payrolls (as a proxy for economic activity). If we assume that inflation will be unchanged to marginally higher (rational due to the general economic malaise globally) and payrolls remain somewhat soft, then we can make the assumption that interest rates should not be significantly increasing in the near-term and an increase of fifty basis points should be a rational upper bound.
Combining the range and the outlook, we get a ten year Treasury note range of 1.50%- 2.50% -- or roughly 0.50% in either direction from the current rate. We can then use this range to determine the mREITs' sensitivity to this range.
Net interest margin sensitivity is the sensitivity of the spread between the funding rate and the portfolio yield to changes in interest rates. Applying our assumption that rates will most likely fall +/- 50 basis points from current levels, we see the following interest rate sensitivities for the chosen mREITs (sensitivities taken from 10Q):
Annaly can be expected to have the most volatility in interest margin should rates change from the current levels while Hatteras should have the least amount of volatility should rates change from their current level.
A closer look at portfolio values given a change in interest rates shows the following:
From the above chart, we can see that the impact on portfolio values given a 50 basis point change in rates is muted, with the largest impact affecting Armour Residential.
Bottom Line: As with any investment, the analysis begins with the investor's assumptions about the current and expected market direction. With mREITs, the analysis is no different. While it is tempting to categorize these investment vehicles as interest sensitive and sell down positions due to recent interest rate moves, the prudent approach is to determine how they will perform given an investor's outlook.
My outlook on rates is that we will range between 2.00% and 2.50% on ten year Treasuries, so I am inclined to own those mREITs that should benefit from steady to increasing rates. Of the above mREITs, Annaly and Two Harbors best fit my assumptions. As I currently own American Capital Agency and Two Harbors, I will be swapping out of American Capital and into Annaly, but reducing the position in order to overweight Two Harbors as there should be less volatility.
Additional disclosure: This article is for informational purposes only, it is not a recommendation to buy or sell any security and is strictly the opinion of Rubicon Associates LLC. Every investor is strongly encouraged to do their own research prior to investing.