Mortgage rates have continued to surge during the third quarter. I believe the volatility in interest rates will continue until uncertainty around QE3's unwinding prevails. Given the situation, mortgage REITs are expected to suffer from additional book value declines. So the rates stabilize, an investment in mortgage REITs is not advisable. Despite the dim future of these companies, insiders have started increasing their stakes in the stocks.
Since the start of the current quarter, the average 30-year fixed mortgage rate has climbed 11 bps while average yield on 10-year Treasury has surged 19 bps over the same time period. I believe the rates will continue to climb until the Fed gives a clear signal about the halt of its third round of quantitative easing.
Rising rates mean decline in the value of fixed-rate instruments. Mortgage REITs invest in mortgage backed securities, which are fixed-rate in nature. An immediate downside of the rise in rates is the decline in the book values of such mortgage REITs. Mortgage REITs that invest exclusively in fixed-rate residential Agency backed MBS securities are most exposed to declines in book value.
Annaly Capital Management (NLY) is one of the largest mortgage REITs that invest in fixed-rate mortgage backed securities, which are backed by government guarantees. The company recently announced that two of its top executives increased their stakes. On August 14, director John Schaeffer and co-CIO Kris Konrad added 40% and 8.5% to their stakes at average prices of $12 and $11.72 per share. Earlier another director increased his stake in the company by 40%.
So, the management seems to be bullish on the future of Annaly Capital Management. Since the management is considered to have a better insight into the company's future, the question is whether you should follow the footsteps of the management? I can find no reason to buy Annaly Capital Management when my most recent analysis reveals that its book value and future dividends will be under continued pressure.
Apart from the better-than-expected EPS for the second quarter, I find no positive stock price driver. Excluding one-time gains, Annaly Capital's EPS comes out to be $0.31 per share, far below the current $0.4 per share quarterly dividend rate. Yes, Annaly Capital has been realizing a gain on sale of securities for some time now, but we need to understand that these gains are not part of the regular operations of an mREIT. Also, despite the continuous occurrence of these gains, the company had been forced to cut its dividends. Additionally, analysts at Barclays believe the support provided by gain on sale will be limited in the future. So, Annaly's dividends are under an obvious danger.
As far as its book value is concerned, the management has not re-positioned its portfolio to a defensive position as imagined. The interest rate sensitivity of Annaly's book value has deteriorated over the prior quarter. Now, if interest rates go up 50 bps, the company's book value will decline nearly 9%. Previously, a 50 bps rise in the rates meant 0.57% decline in the book value. So, its book value is more exposed to changes in interest rates now. With that said, I would not follow the footsteps of Annaly's top management until I find some portfolio re-balancing that is aimed to providing cushion to future book value erosion.
Invesco Mortgage Capital (IVR) is another mortgage REIT that reported insider buying recently. Unlike Annaly Capital, Invesco is classified as a hybrid mREITs and usually hybrids are being preferred under the prevailing macroeconomic situation. Invesco reported that its CEO purchased more stock of the company to increase his stake by 13%. Shares were bought at an average price of $15.4 per share.
Despite being classified as a hybrid mortgage REIT, Invesco reported 12.4% erosion in its book value while core EPS of $0.59 per share remained behind its quarterly dividend distribution of $0.65 per share. The reason for Invesco's underperformance is the design of its investment portfolio. Nearly 53% of its second quarter-end portfolio is composed up of the troubled fixed-rate Agency residential MBS. This abundance of Agency residential MBS provides the company with little diversification, causing it to behave more like an Agency-only mREIT. So, I believe this is one of the hybrid mREITs that I would not prefer.
Despite the insider buying at Annaly Capital Management, I reiterate my opinion that investors must stay away from the stock until either the rates stabilize or there are signs of significant portfolio re-balancing aimed to securing further decline in book value.
Additional disclosure: Equity Whisper is a team of analysts. This article was written by our Financials analyst. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.