mREITs have taken a battering so far this year as speculation about the Fed tapering off its bond buying program has resulted in a sharp spike in interest rates; the 10-year treasury yield is close to touching the 3% mark, a rise of 120 basis points from the 1.8% yield at the start of the year. As interest rates rise, bond prices fall, and so do the book values of mortgage REITs. Now that the much-anticipated taper is just about to happen, mREIT investors should understand how these stocks could react to the Fed's decisions.
The Fed is highly likely to taper later this month
There has been a lot of speculation as to when the Fed will start to taper off its QE. There are many investors who still believe that the Fed will not announce the taper this month; with the implication being that treasury yields should fall and mREIT stocks should get a boost.
However, I am of the view that the taper would happen this month. FOMC minutes from July show that members were "broadly comfortable" with chairman Bernanke's timeline to moderately reduce the Fed's bond purchases later this year. And if the taper has to happen this year, the decision has to be made at one of the three remaining FOMC meetings to be held on September 17-18, October 29-30, and December 17-18.
From among these dates, September appears to be the most politically suitable choice. The month of October is likely to be shrouded by the debt-ceiling debate, and President Obama may also nominate his choice for the next Fed Chairman in October or November.
December would Fed Chairman Bernanke's second-last month in office, and after building legacy as a huge monetary policy dove throughout his career, I would not expect Bernanke to give the U.S. economy a potential negative shock as one of his last acts as Fed chairman, and that too just before the Christmas holidays.
The composition of the taper
Whether the Fed acts in September, October or December, the taper is coming; so for mREIT investors, the more pertinent question would be regarding the amount by which the Fed will reduce its treasury and MBS purchases.
The street is of the view that any possible taper announcement will be frontloaded with a reduction in treasury purchases in order to prevent the disruption of a fragile housing recovery.
However, there are reasons to believe that the Fed might be forced to cut down on its MBS purchases faster than expected. Let me recall the remarks made by Dallas Fed's Richard Fisher back in May regarding the Fed's MBS purchases:
"In recent months, under its balance-sheet expansion program, the Fed has bought about 50 percent of gross issuance of agency MBS, partly to replace prepayments of our MBS holdings. When refinancing activity eventually shifts down, the Fed could soon be buying up to 100 percent of MBS issuance if the current purchase program continues. I believe buying such a high share of gross issuance in any security is not only excessive, but also potentially disruptive to the proper functioning of the MBS market."
Well, the time that Fisher rightly warned us about is here. Since his remarks in May, we have seen a sharp spike in interest rates, which has led to a steep decline in refinancing activity; Mortgage Banker Association's refinance index is at its lowest level since June 2009. The chart below shows the MBA refinance index since the start of QE3.
Chart via Market Realist
You can clearly see how the refinancing activity has dropped since the taper speculation started in May.
The fall in refinancing activity leads to a fall in mortgage origination activity. The chart below shows the gross monthly agency MBS issuance from mid-2012.
Data from SIFMA
You can see that the MBS issuance volumes started to fall right after the Fed hinted about the possibility of taper back in May.
On the recent decline in MBS issuance, Fisher said:
"We hold more than 25 percent of MBS outstanding and continue to take down more than 30 percent of gross new MBS issuance. Also, our current rate of MBS purchases far outpaces the net monthly supply of MBS…the point is: We own a significant slice of these critical markets"
Thus with MBS origination slowing down, I believe that the Fed may have no choice but to cut down its MBS buying, or else it would risk an untowardly disruption in the MBS market. While the market focuses on the relatively soft employment numbers, you must not forget that macroeconomic data is no longer the only reason driving the Fed's decision to cut down its asset purchases. That is another reason why I believe that the Fed would want to taper starting this month.
Implication for mREITs
Thus far this quarter, we have not seen the MBS spreads widen like we saw in Q2. However, this could change if the Fed announces that it would cut down its MBS and treasury purchases at a faster pace than the market expects.
In such a case, agency mREITs that have a large positive duration gap and/or are highly leveraged could suffer sharp losses. Popular mREITs like ARMOUR Residential (ARR) and American Capital Agency would fall into this category.
As of June 30, ARMOUR Residential had a leverage ratio of 9.77x which is very close to the company's upper limit of 10. Thus if there is a sharp spike in interest rates, ARMOUR could be in trouble because it would be forced to cut down the size of its portfolio at potentially unattractive prices, resulting in a large book value loss. In its latest 10Q filing, ARMOUR Residential estimated that a +100 bps interest rate shock would cause its net interest income to fall by over 12%.
Similarly, American Capital Agency (AGNC) had a leverage ratio of 8.5x at the end of the second quarter which is once again on the higher side. In its latest 10Q filing, American Capital Agency estimates that its Net Asset Value would fall by 5.9% in response to an instantaneous 100 bps rise in interest rates. However, unlike ARMOUR Residential, American Capital Agency expects its net interest income to rise 1.3% in such a scenario.
Although Annaly Capital Management's (NLY) leverage ratio of 6.2x is relatively lower as compared to ARMOUR and American Capital, its portfolio is still highly sensitive to interest rate changes. Annaly Capital estimates that its portfolio's Net Asset Value would fall by almost 15% in response to 75 bps instantaneous rise in interest rates. However, Annaly's foray into the commercial MBS market with its acquisition of Crexus Investment gives the company the benefit of diversification that ARMOUR and American Capital lack.
In such a situation, I believe that Capstead Mortgage (CMO) could be the safest choice within this sector. Unlike American Capital, Annaly and ARMOUR that focus heavily on long duration, fixed-rate 30-year agency securities, Capstead invests almost exclusively in short duration Adjustable Rate Mortgages (ARMs) that reset to the more current interest rates within 5 years or less. Thus, Capstead mortgage takes on much lower interest rate risk as compared to its 30-year fixed-rate focused peers.
Capstead's book value performance in Q2 tells you all you need to know; while most agency mREITs suffered 15-20% book value losses from Q1, Capstead's book value per share declined by just 3.8% as a result of changing market conditions. Of course, you would have to accept a lower historical dividend yield along with the lower risk, but in return, you should get stronger book value preservation as compared to other names in the agency mREIT sector.
My advice: play it safe
I might not know exactly when the taper is coming, or what its amount and composition will be; but what I do know is that the next few months will bring a lot of uncertainty, and with uncertainty comes volatility. Even if the Fed's taper is seen to be "dovish," the interest rate environment would remain highly volatile due to the upcoming debt ceiling debate as well as the decision on the next Fed chairman. When the volatility is high, the cost of hedging goes up and net interest spreads shrink. Thus investors could possibly see book value declines combined with a pressure on net interest spreads, which could be a very bad situation indeed.
If you are a retiree, I would recommend that don't allocate a large portion of your portfolio to the agency mREIT sector by blindly chasing historical dividend yields; in my opinion, the next few months could be very tough.
If you are a risk taker, I believe that the next few months could bring an excellent buying opportunity in this sector once the volatility settles down.