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The belief that the Federal Reserve will be slowing its bond buying program has hammered the market for mortgage real estate investment trusts (mREITs), and with it has battered the prices of these dividend paying machines. The primary driver of this action were rising interest rates. These publicly traded trusts buy mortgage bonds with borrowed money, thus as interest rates rise it costs more to borrow. If the long-term rates don't keep pace, or exceed the rate of growth in shorter-term yields, we will have a narrowing of the interest rate spread due to a flattening of the yield curve. In fact this yield spread is key to mREIT profits because these companies borrow capital at very low short-term rates, and then invest in potentially higher yielding real estate mortgage assets. The companies also magnify their risk because they often use leverage to make money off of the spread differential in rates while still paying out gargantuan yields to investors on a regular basis. The fear that these interest rate spreads will narrow and diminish profits, coupled with a move in the last few weeks higher in yields, has resulted in my long-time favorite mREIT, American Capital Agency (AGNC), to suffer double-digit losses in just a few short weeks, and is currently trading at $25.49, after being over $30.00 to start May.

It's all about the interest rates

As pointed out above, the interest rate spread is a key driver of profitability. Besides a narrowing of the spread, there are other issues that can arise which hurt AGNC's business model that you may not be cognizant of. First, the companies often leverage their risk. As we know, the mREITs borrow in the short term to buy longer-term mortgage securities, earning the spread between the two. But what some may not realize is many companies also use repurchase agreements to leverage their holdings, in some cases up to 8 times. AGNC itself is currently leveraged 6.5 times (at the end of Q1 2013), which is down from a 7.5 times leverage at the end of Q2 2012. Still, this leverage magnifies risk substantially (while also increasing potential reward). Returning to the interest rate spread potentially narrowing, the interest rate spread at the end of Q1 2013 was 1.52%, down from 1.62% at the end of Q4 2013. This number will be a key metric when the company reports its Q2 results this summer. If it drops below 1.3%, it would mark a multi-year low. Looking to the leverage and the interest rate spread are keys to determining what type of profit AGNC will be looking at. To get an idea of how Q2 is going, we should review where interest rates are right now.

Where are interest rates right now?

To give you an idea of what rates have been doing, it would be useful to see the action in mortgage rates so far during the quarter. The higher rates go, the less demand we will see for mortgages as consumers may not be able to afford additional monthly payments on a home, and in turn can hurt AGNC's business. As of the time of this writing, the current interest rate for a 30-year fixed rate mortgage in the United States is 4.04% whereas the shorter 15-year fixed rate mortgage is 3.14%. At the start of the quarter these rates were 3.5% and 2.8%, respectively. Over the last month, interest rates have risen, pressuring consumers, commercial borrowers and mREITs, primarily for fears the interest rate spread is diminishing and that the residential housing market could weaken. This is in addition to fears (whether rational or irrational) of a tapering of Fed asset purchases that could impact the mREITs' business operations and pressure margins. Figure one illustrates the massive rise in interest rates over the last month.

(click to enlarge)

So, the month of May has seen a large sell-off in mortgage-backed securities, which have fallen in value as long-term interest rates have risen, and markets continue to price in a Federal Reserve tapering. In turn, the selling caused prices to drop further, which has created massive pressure on AGNC's stock price. At the time of this writing, mortgage-backed security prices are on the decline. Figure two shows the price of the June settlement 30-year FNMA 3.5 price.

Figure 2. Price of the FNMA 3.5 Mortgage Backed Securities in the last month.

(click to enlarge)

As shown in figure 2, the price of mortgage backed securities is dropping dramatically along with the sudden rise in interest rates depicted in figure 1. This is one example of a mortgage backed security suffering. However, other mortgage backed securities, such as the GNMA 3.5, the FMNA 4.0 etc., are all dropping as well. This could seriously pressure the profit margins of AGNC in the second quarter.

Is this an opportunity?

I recently opined that I believed the book value at the end of Q1 to be lower than where I thought it currently was in the beginning of May. At this time, the information is changing. With the rise in interest rates and the dropping value of mortgage backed securities, book value could easily now be lower. Management will have to make decisions on whether to leverage down, stay on the sidelines, or if they believe this is temporary, make some portfolio changes/additions. I am inclined to believe as both a shareholder and student of the markets that this rise in interest rates is too far, too fast. I think this is a temporary spike that will soon settle lower. While the rise may be good for banks that are lending by helping their profits, it could seriously jeopardize the fragile recovery we have seen. Housing has been very strong as of late, but this action could quickly change given these rate hikes. I think the Federal Reserve absolutely does not want the interest rates to rise this quickly as it undermines their intervention into the bond market and asset purchasing program, which was designed to keep demand up. Thus, I think this may make it less likely that the Fed will taper, and they may try to influence rates further to turn them lower. In turn, this could be an opportunity for investors who are looking to get into the mREIT space. If the rates start to trickle lower, I suspect a rally will ensue in what I consider an oversold stock in AGNC.

AGNC currently trades at $25.49. I will be watching interest rates closely over the next few weeks for signs that the growth in rates has ceased. Further, I will be watching the non-farm payroll report. If this number comes in above 200,000, it is likely that the Fed tapering talk will spike, potentially presenting a buying opportunity in AGNC under $25.00. For the long term, AGNC will be profitable, and for investors with a long-term horizon, I think it has a place in a portfolio that is reinvesting dividends. While the dividend will surely fluctuate over time, slowly building a position in your portfolio in increments on the way down is a key to long-term success. For those trading the stock, simply watch interest rates. The higher they go, the more pressure on the stock in the short term. When they dip, the stock will likely see a bump. I for one am in for the long haul and plan to allocate 3% of my retirement portfolio to the mREIT space.

Source: American Capital Agency And Rising Interest Rates: Cut Your Losses Or Wait It Out?