Volatility in the mortgage markets have increased since the first quarter and I believe it will not subside anytime soon because the Fed has again linked the QE unwinding with macroeconomic improvements. Given the continuous volatility and widening of the Agency MBS spreads, I recommend investors stay away from the pure-play mREITs. Therefore, the hybrids are preferred. However, not all the hybrids will outperform. Today, I will feature two such hybrids that I believe will experience significant book value erosions.
Agency mREITs in trouble
With the second quarter's end in sight, I believe significant book value erosions would be the limelight of most of the upcoming earnings disclosures by mortgage REITs. The April rally in the rates, coupled with the material selling off will cause most of the Agency mREITs including American Capital Agency (AGNC) and ARMOUR Residential (ARR) to report book value erosions.
American Capital Agency, in a latest presentation, acknowledged that its book value has seen a decline similar to the one during the first quarter. On further fears of book value declines, Barclays has already downgraded it. Besides, it has also reduced its dividend distribution 16% to $1.05 per share. The company also attempted to rebalance its portfolio. However, the rebalancing efforts are expected to further decline its earnings. As of June 7, 2013, the company's duration gap increased to 0.7 years from -0.2 year. This will further increase book value erosion if the rates continue to increase.
In an upset announcement, ARMOUR Residential declared its third quarter's dividend in line with the second quarter's distributions. However, the fundamentals reveal another story. The company's duration gap increased to 1.47 years from 0.2 years on May 8, 2013. Besides, its new production MBS, which were purchased after the recent equity raise, perform worse during the current environment.
Therefore, the Agency space remains the least favored amid this environment.
Are hybrids any better?
Given the situation, hybrids are the most preferred type of mortgage REITs. That's because their large exposures in the non-Agency residential MBS are considered less sensitive to interest rates moves. However, not all hybrids will outperform. Invesco Mortgage (IVR) and JAVELIN Mortgage (JMI) are the two hybrid mortgage REITs which will experience significant book value erosions.
The nature and design of the asset portfolio of Invesco Mortgage leads me to think that it will experience significant book value losses. That's because around 57% of its entire assets portfolio is the 30-year fixed rate security, while the Agency holdings account for 70% of the entire portfolio. Only 17% are non-Agency MBS. Therefore, its portfolio acts more like an Agency mREIT's portfolio exposing the book value to interest rates moves. Any news of reduction in the 30-year fixed rate exposure will be good news for Invesco's investors.
JAVELIN Mortgage is the sister concern of ARMOUR Residential. It has a little portion (11%) of non-Agency MBS in its portfolio, which qualifies it as a hybrid mREIT. However, I believe it's not enough to provide cushion to the company's eroding book value. From May 8 to June 7, 2013, the company's duration gap increased to 1.71 years from -0.15 years, further exposing its book value to erosions. I believe, JAVELIN needs to increase its exposure in the non-Agency space in order to survive the current conditions.
I believe the pure-play mREITs are not alone in their fears for a book value decline. While you should expect declines in book values of American Capital Agency and ARMOUR Residential, significant declines in the book values of Invesco Mortgage and JAVELIN Mortgage can't be ruled out. Therefore, caution is required before investing in hybrid mREITs.