The market prices of agency mREITs have plummeted over the past months. I argue that this drop was fundamentally warranted and that mREITs will drop even further as the 2nd quarter results roll in. This article will delve into the financial inner workings of these companies to develop and support a thesis for weak 2Q performance.
Framing the argument
We must notice that the volatility of interest rates is very different than the overall change.
If we only look at the overall magnitude of difference between 3/01/13 and 5/31/13, interest rates appear to have changed very little over 2Q13.
This would bode well for the mREITs, as they are highly sensitive to changes. However, The end result is not the only relevant piece of information. We must also know how it got there. Below are 2 hypothetical paths.
Both paths have the same starting and ending points, but the actual effect on the 2Q performance of mREITs would be drastically different. Along path A, the securities held in mREIT portfolios would lose a slight amount of value, but the companies would be fine. Path B could potentially cause bankruptcy.
Obviously both paths represent the extreme cases and are not reflective of reality, but it is important to understand how each path affects mREITs.
mREIT Sensitivity to Interest Rate Changes
Investors familiar with fixed income investment already know about the duration effect. Essentially, the price of fixed income assets will move inversely with interest rates and the magnitude of change is proportional to the duration of the asset.
mREITs have additional parameters to worry about. While the duration of most fixed income instruments is a constant, the duration of the assets of mREITs tends to change as interest rates change. This negative convexity amplifies the harm to book value of rising interest rates and cancels much of the gains as rates drop due to increased prepayment.
Consequently, mREITs have an interest risk profile that looks like this
An interest rate shock in EITHER direction tends to decrease the book value of mREIT portfolios. While the specific data in the chart above is that of American Capital Agency (AGNC), it is fairly representative of the entire sector.
Now that we have a framework from which to make an argument, we can look at what interest rate changes actually occurred in the 2nd quarter.
The Drop through March and April
Interest rates at the start of May were substantially lower than in March.
The Rapid rise in May
In just the month of May, interest rates on the 10 and 30 year treasuries rose nearly 50 basis points. Some people would argue the technicalities of what time period qualifies as a "shock" and whether or not the change was parallel, but this is as close as reality gets to a parallel interest rate shock.
Putting it all together
While the rate at the start of 2Q13 was only slightly lower than the rate at the end of 2Q13, the volatility that occurred within the period spells disaster for the book value of agency mREITs.
During March and April when the interest rates were rising, homeowners were incentivized to refinance. Consequently, CPR or constant prepayment rate was likely very high. Given the premiums at which most of the agency mREITs bought the securities, prepayment at par creates a significant loss immediately and forces the REIT to have to reinvest at a lower rate.
In May, 10 year and 30 year interest rates spiked back up beyond what they were at the start of the 2nd quarter. This directly lowers the carrying value of fixed income assets and agency MBS are no exception.
The 2nd quarter interest rate volatility and its effects on agency mREITs are summarized on the graph below.
While mREITs do attempt to hedge against interest rate risk, this is usually done through options that become "in the money" upon interest rates rising sufficiently. Such a hedge partially protects mREITs from rising interest rates.
However, as the interest rate at the end of the 2nd quarter was not all that much higher than it was at the start of it, I believe that many of the hedges will fail to come to fruition. Hedges designed to protect against overall increases or decreases in interest rate do little to protect against volatility. What we saw in the 2nd quarter was very little overall change, but lots of volatility. This is precisely the sort of pattern that hurts the book value of mREITs without triggering the guardian angel that is the hedges.
To whom it may concern
Investors who have positions in the following securities would be wise to prepare for potential losses as 2Q earnings reports come in.
- American Capital Agency
I believe AGNC will be among the most affected given its nearly 6X leverage. It may be forced to cut its dividend which could further the decline in its market price.
- Annaly Capital Management (NLY)
Annaly may also be heavily afflicted as it is even more levered with 6.76X debt to equity and holds a fairly long duration portfolio.
- Armour Residential REIT (ARR)
Armour has been issuing equity non-stop, so its difficulties could be amplified depending on when the new capital was deployed. As the efficacy of newly deployed capital could vary greatly even over the course of a week, it adds an extra degree of uncertainty going into their 2nd quarter results.
- iShares Mortgage REIT ETF (REM)
As the interest rate volatility will affect the entire sector, it will undoubtedly be felt in this index ETF.
Interest rate changes are only one piece of the pie, and I am not suggesting that mREITs are doomed. Instead, this article is intended to portray a substantial headwind that will likely adversely influence 2nd quarter results.
Disclaimer: This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.