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The second quarter of 2013 was tumultuous for mortgage real estate investment trusts (mREITs). The Fed's taper announcement created a storm which caught most unsuspecting and under-hedged. The market sold mREITs off as rates rose, in many cases correctly anticipating significant book value declines. However, a few -- AI, EFC, NRZ, and CMO -- had already battened down their hatches and thus suffered only minor damage. Others -- AGNC, MTGE, MITT -- were late to prepare for the danger, but eventually followed suit, reducing their leverage and increased their hedges. Q3 earnings, now upon us, are likely to reinforce that not only was the storm survived, but most in the mREIT industry are now more cautious and better prepared to weather future challenges. Moreover, the fourth quarter is starting with a favorable wind at their backs and clear sailing ahead.

Q3 has been an interesting quarter for the world, but relatively benign for mREITs. Mortgage Backed Security (MBS) values were stable during the quarter, drifting down in anticipation of a September taper, then back up at the end of the quarter when that taper didn't happen. The 4% coupon, 30-year MBS for example, changed from a price of 103.88 at the beginning of the quarter to 104.53 at the end; a less than 1% increase. Indeed, this < 1% change was generally representative of overall 15 and 30 year MBS prices. Put another way, while most mREITs significantly lowered risk by reducing leverage and increasing hedging, for Q3 at least, it turns out it wasn't needed. Also reinforcing this benign outlook for Q3, EFC, CYS and AGNC have already reported with essentially flat book values and positive economic returns (economic return = dividend + change in book value). Expect much of the same from the rest of the mREITs as they report earnings, flat book values, positive economic returns, resulting in a gradual calming influence on the sector. This, and the reduced risk profiles, should help to settle fears of continued MBS and book value losses.

We may also see a trend of small and gradual increases in interest rate spreads. mREITs make their money by borrowing at short term repo rates and using those funds to buy MBS paying longer term, predominately higher, mortgage rates. This is commonly referred to as the spread. However, increased spreads were not immediately apparent in Q2 despite a roughly 1% increase in mortgage rates. What may not have been taken into consideration is the suddenness of the change. Rates affect book value immediately, but there can be a delay before the portfolio of assets an mREIT holds rolls over into higher spreads. Also many mREITs increased hedging at the end of q2, the cost of which further reduced the spread. For Q3 earnings announcements, we could see some of these increased spreads start to come through. This should have a further calming influence on mREIT investors and reinforce that higher interest rates aren't all bad news. Indeed an environment of gradually mortgage rates changes, largely hedged book values, and continuing low short term rates, can be beneficial.

Looking into the future, we have some wind at our backs. Janet Yellen has been nominated as the new Fed Chairwoman. While anything can happen, it is widely suspected she will be confirmed. Furthermore, Mrs. Yellen is a known dove. Indeed she has been a noted proponent of keeping interest rates low until unemployment improves significantly. It is unlikely her first act as the new Chairwoman would be to raise rates, particularly with another debt crisis and partial government shutdown looming. It is therefore unlikely we will see the beginning of taper until at least March, maybe longer if the economy doesn't keep improving. Assuming a slow taper of $10B starting in March, you are probably looking out into the beginning of 2015 before the Fed is done. That means the Fed continues to add to its overall bond holdings through all of 2014 and most likely doesn't start actually increasing the Fed funds rate until 2015. That is a good environment for mREITs, BDCs and any other company which benefits from borrowing short and lending long. This is a case where poor economic growth and a dysfunctional government is a good thing for mREITs.

mREITs are likely to be looking at a calming and profitable Q3 with an improving outlook over the next 3-6 months, reduced leverage and significantly hedged book values. In this situation investors should realize that existing discounts to book are largely unwarranted. The discounts should shrink over time, producing capital gains. Fear has created an opportunity; mREITs offer not only high dividends but their current discounts provide a margin of error. As such they should be over-weighted in income focused portfolios.

Source: Clear Sailing Ahead Likely For The Mortgage REITs

Additional disclosure: Darren McCammon manages private accounts through Proactive Financial LLC as well as the income focused 50+ portfolio at Covestor.com.