The mortgage REITs sector continues to face pressure in the event of another confusing signal by the Fed. I'm talking about the Fed's signal to taper the massive easing. Yes, it's confusing because it's still linked to improvements in the economic conditions, which continue to give mixed signals. This confusion has given rise to volatility in the interest rates, and the Agency mortgage spreads have widened further. Given the situation, some mREITs continue to suffer more than others. Let's see why.
Mortgage market update
Volatility in the interest rates is amplified, as confusion about the Fed's exit from the Agency MBS markets prevails. The Agency MBS spread has gone up another 8 bps to a 20-month high of 3.29%, causing the mortgage REITs to tumble down as they (NYSEARCA:REM) fall another 3.5% in one day. At the same time, American Capital Agency (NASDAQ:AGNC) and ARMOUR Residential (NYSE:ARR) fell 4.3% and 3.4%, respectively.
This has also caused a slide in the mortgage in MBS prices, which might eventually be a great opportunity for the mREITs, but for now the book value erosion may further increase.
American Capital Agency least preferred
American Capital Agency has become from one of the most preferred Agency mREIT to the least preferred mREIT. Thanks to the abundance of highly prepayment protected MBS held by the company. These MBS are best suited for a declining interest rate environment. However, in contrast, the rates are on the rise. That's why, the company reported around 9% erosion in its book value during the first quarter, while another 9% has already eroded during the current quarter.
While the management decided to rebalance its assets portfolio to tilt it away from the 30-year fixed rate MSB and to actively manage its assets and hedges, this effort would also hurt American Capital's earnings potential. Therefore, on concerns of a further decline in the book value and lower earnings potential, analysts at Barclays have downgraded American Capital Agency to equal weight.
American Capital Agency is down 19% since the Mid of May and trading at 16% discount to its first quarter book value. The company also recently announced a 16% decline in its second quarter's dividend. However, the decline was less than expected.
Hybrids most favorite
Given the situation, hybrids are the most preferred option for investors who wish to expand their regular income. Among the hybrid mREITs, Two Harbors (NYSE:TWO) tops the list of analysts at Credit Suisse, Deutsche Bank and Barclays. CYS Investments (NYSE:CYS) is another option within the pure-play mREITs space.
Two Harbors is expected to enjoy a lot of support from its new investments in credit sensitive loans and the MSRs. What's interesting is that during the presentation, the management at Two Harbors disclosed that company's book value remains unchanged from March 31, 2013. That's because of the defensive positions the company took against interest rates. Also, a relatively lower level of leverage and the presence of credit sensitive assets provided some support.
CYS Investments is another Agency mREIT but has a very different investment portfolio compared to American Capital Agency. While they are both exclusively invested the Agency MBS space, CYS Investments only has adjustable-rate securities in its portfolio. These securities adjust their regular payments to the more current interest rates at the next reset date, which causes minimum fluctuations in the book value of the company. Since, the company's receives coupons adjusted upwards to the most current rates and its book value is also secured from any volatility, it's one of the best options under the current scenario.
Given the volatility in the interest rates and the prevailing confusion about the unwinding of the QE, I would recommend you stay away from American Capital Agency and ARMOUR Residential for some time. Hybrid mREITs provide a better opportunity to expand your regular income. Within the hybrids, Two Harbors has the highest potential to increase its earnings and protect its book value.