Mortgage real estate investment trusts (mREITs) such as Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) combine characteristics of both equities (with Beta of about 0.5 currently) and fixed income. Assuming no price appreciation, mREITs' double-digit dividend yields exceed our firm's expected return for U.S. equities that was recently reduced, and far exceed other fixed-income alternatives. I think the iShares Mortgage REIT Capped ETF (NYSEARCA:REM) currently presents an attractive risk-return opportunity.
We have monitored this asset closely since my favorable July-2013 article: the price is currently about the same as it was in July, while it paid two attractive quarterly dividends.
To achieve higher yield, mortgage REITs finance a portion of their investments by debt in addition to equity. The largest ETF based on mortgage REITs is the iShares Mortgage REIT Capped ETF, with $1.2 billion in assets. Annaly (NLY) (~15%) and American Capital Agency (AGNC) (~12%) are REM's largest portfolio holdings.
Mortgage REIT prices were hit hard last year when long-term interest rates jumped by about 1% in response to the Fed announcing its tapering plans. REM's price dropped 20% in May-June of 2013 (the red line on the chart).
mREITs are essentially portfolios of long-term mortgages, financed by short-term [REPO] borrowing. The asset-liability duration mismatch is partially (but not fully) hedged with swaps, so the portfolios remain long-duration. Thus, there are two main sources of risk and return in mREITs:
- mortgage credit spread
- duration exposure to long-term (about 10y, on average) interest rates1
We calculate REM's exposure to 7-10 year interest rates to be 1.9 times that of 7-10 year Treasuries, an effective duration of about 14 (it means that if rates rise by 1%, the price would drop by 14%). This explains most of the price drop last year. We can also see that duration has risen significantly since 2011 - likely due to mREIT management choosing to keep a larger portion of their portfolios unhedged to take advantage of very low short-term rates.
mREITs pay most of their income as dividends, which the ETF passes through. At the current price and using trailing 12-month dividends, REM's dividend yield is a whopping 14.6%. Higher long-term rates would not typically affect an mREIT's income (unless the company made portfolio changes, for example to hedge). This was confirmed by actual REM's dividends paid in Q3 ($0.42) and Q4 2013 ($0.48) - they declined only slightly from the peak of $0.53 in Q2 (see chart below). I look back at the $1.54 annual dividend in 2011 as an indicator of what level to expect if mREITs hedge their duration (they were mostly hedged back then). At the current price, this gives a yield of 12% - a reasonable, and perhaps conservative, expectation for REM's future return, in my view.
Credit default risk, typically the largest risk in mREITs, has improved since the real estate crisis: mortgage foreclosures and delinquencies normalized, and loan-to-value ratios improved due to the rise in housing prices and to more strict underwriting standards for new mortgages since the crisis (no more zero-down or stated-income "liar's" loans). As a result of the low interest rate environment and of management decisions to reduce interest rate hedging, interest rate risk came to the fore. With REM's interest rate exposure double that of 7-10y bonds, analyzing mREITs involves a view on interest rates. Currently at 2.75%, I think that 10y Treasury yield is settled for a while in a range between 2.5% and 3%, as the Fed's reduction of its bond-buying stimulus is largely priced-in by the market.
The table above compares REM to some alternative fixed-income asset classes. At 12%, REM's expected yield is 2.6 times the yields on the next highest alternative: high-yield bonds (after ETF expenses). It also surpasses our firm's current six-month return forecast for U.S. equities. I think that at this point, investors would be paid well for taking interest rate risk in REM.
1. To be more precise, it is the slope of the yield curve between 10y swap and short-term Repo rate that matters. As the Fed committed to keep short-term rates low for an extended period of time, the risk of a rising Repo rate is currently low.
Disclosure: I am long REM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.