It has been a rough second quarter for the mortgage REIT stocks. Rising mortgage and other interest rates have resulted in lower mortgage-backed security prices, eroding book values for the agency mREITs and producing double-digit share price drops. As of June 14, the iShares FTSE NAREIT Mortgage REITs Index ETF (REM) is down 11.5%, compared to 3 months ago. With the evidence now evident to all, I thought it would be a good time to go over the price and yield.
REM data by YCharts
In the world of free Internet information, it can be difficult to find good data on historical MBS pricing. I recently discovered that ARMOUR Residential REIT, Inc. (ARR) publishes a monthly update that provides some fairly detailed information on the pricing of its MBS portfolio. ARMOUR Residential owns about 90% fixed rate MBS and the balance is adjustable rate loan agency mortgage securities. The portfolios of the two other major agency mREITs, Annaly Capital Management (NLY) and American Capital Agency Corp. (AGNC) own very similar agency MBS portfolios and the value results of these companies should be more or less similar to what ARMOUR Residential has provided.
February to June Results
As a baseline, in February the ARMOUR MBS portfolio had an average purchase price and value of 104.8% of par. The average net coupon yield was 3.36% and the estimated effective duration was 4.48 years. The value of the portfolio was $26.94 billion.
Fast forward to June and while the average purchase price remains at 104.8%, the market value has dropped to 103.0%. The price drop plus any principal repayment puts the dollar value of the portfolio down $3.27 billion to $23.67 billion. Keep in mind that ARMOUR Residential has a market cap of around $2 billion. Falling prices are really not a good thing with 8 to 1 leverage of your capital.
For me the most interesting change over the 4 month period was the extension of the portfolio effective duration out to 5.41 years. The root cause of the increase in the duration can be seen in the constant prepayment rate of the portfolio, which average 18% per year in January and February, and by May and June the CPR was in the 10.5% range. As rates rise, a lot fewer homeowners want to refinance or pay off their home loans.
Its All Up to the Hedging
As you may be able to see from the numbers provided above, pass-through, low-coupon, mortgage-backed securities are probably the worst possible fixed-income class of security to own in a rising rate environment. Over the period of time we are looking at, mortgage rates increased from 3.7% to close to 4%. The 10-year Treasury went from 1.9% to 2.2%. ARMOUR's portfolio lost 12% of its value. Imagine the value erosion if the Treasury rate goes to 4% and mortgages cross the 5% threshold.
Since the mREITs are REITs, they are stuck with the MBS market and are forced to use interest rate swaps, swaptions and Eurodollar futures to hedge against the MBS value drops when rates rise. The challenge of this approach is that the hedge instrument values are based on Treasury or Eurodollar interest rates and not directly on MBS prices and yields.
The results for the mREITs and for investors who own shares in these companies depend on the effectiveness of the hedging strategies use by the individual companies. It will not be until we go through a couple of quarters of rising rates before we can determine if the management teams of these companies got it right with their hedges.
If you read the same news I do, you are starting to see more and more discussion that the low yield bond environment is over, and investors will no longer accept the yields that have been in effect for the past few years. You must decide if the last 4 months are a temporary uptick in bond and mortgage rates or if this is the start of a trend.
If rates are truly in an up-trend and bond prices, by association, are heading down, the best you can hope for from the mortgage REITs such as ARR, NLY and AGNC is to not lose too much money before rates stabilize. Higher rates mean lower MBS prices, lower prepayment rates and less cash available to reinvest at the new higher rates to catch up with interest cash flow. And it is possible that as MBS rates increase the lenders providing the repo funds to leverage the MBS portfolios will want a piece of the action and charge higher rates on the money the mREITs are borrowing, cutting into the yield spreads. In my opinion, it will get significantly uglier for the agency mREITs before it starts to look better. And I am talking about several years before that happens, not quarters.
ARR data by YCharts