Have you ever had a very bad experience with Mortgage REITs? Just last year, it was painful to watch as Annaly (NYSE:NLY), American Capital Agency Corp. (NASDAQ:AGNC), Armour Residential (NYSE:ARR) and others declined 25% or more in just two months. I understand why we have such distaste for them. It could be because of similarly bad experiences or maybe we just don't like to see such volatile moves. Or perhaps we avoid them because they are so difficult to understand that they keep us up at night if we own shares in any of them... even if just a few shares. They certainly aren't the traditional dividend growers that have increased dividends over long periods of time but hey, they do pay some seriously high dividends in normal economic environments. Should we be investing in them?
Investors who don't know or understand them should certainly not invest in them!! As Peter Lynch has often been quoted as saying:
Invest in what you know
It is one of Lynch's investment principles, and is the concept behind his book, One Up on Wall Street. As investors, we would be wise to follow that advice. But we do have options.
Option 1 - invest ONLY in what you CURRENTLY know
While this can be a very successful strategy, it has limitations and could result in missed opportunities. Our individual knowledge at any given time is finite and when it comes to investing our hard-earned money, we tend to stay in our comfort zone. This is OK, and if you are already knowledgeable about a broad set of topics, you are better off than the next guy. But there is another option.
Option 2 - learn more about the things you don't know and increase your available investment universe.
It's important to also seek to learn more about what you don't know. If you're reading this article, you are probably the type of person that thirsts for knowledge about some topics, whether investment related or not. It's in our nature to be curious about the world and about concepts, principles, philosophies, and topics in general. So the second option is to educate ourselves about the things we don't know so that we can then revert back to option 1, right?
This article will touch on some of the characteristics that differentiate mortgage REITs from Equity REITs and will describe, in simple terms, some of the risks and mitigation strategies employed by many mREITs, and specifically Annaly Capital. If nothing else, I hope you take away a better sense of how mREITs generate profits and what they do to mitigate the specific risks they are exposed to. You may still decide not to invest in them and that's fine. But I hope I shed some additional light on how they operate and if nothing else, leave you with a bit more knowledge about them.
Equity REITs vs. Mortgage REITs
Equity REITs are securities issued by companies that own and manage real estate assets in a variety of sub-sectors ranging from senior housing, apartments, office buildings, cell towers, storage facilities, etc. These REITs own the properties that are leased to lessors in order to generate income that is eventually distributed to shareholders. Even though many Equity REITs are lumped together as a group, each sub-sector has its unique characteristics and is impacted by a different set of drivers. See REITs for a Rising Rate Regime.
Mortgage REITS may be more difficult to grasp because they don't usually own any physical assets like Equity REITs. The main strategy of mortgage REITs is to invest in mortgages or mortgage related securities in order to receive the payments made by the borrower. To further complicate the operations of mREITs, many of them leverage their balance sheets by providing those mortgage securities as collateral for extra capital, which is then reinvested in additional mortgages. The process can be repeated several times and many mREITs have used this strategy to leverage their balance sheet over 10 times.
The financing sources used by mREITs is also not so typical of an Equity REIT or traditional company. Many of them use repurchase agreements for raising capital and combine them with interest rate swaps to hedge against interest rate increases. It's not surprising then that mREITs are so misunderstood. Combine this complexity with higher volatility than the average REIT and you have a security that investors either love or hate.
mREIT business model
Mortgage REITs buy mortgages that pay a coupon, which may consist of both interest and dividend payments. They finance these purchases with short-term financing, usually at a lower interest rate, and earn the spread between the coupon received and the interest paid on the financing. As I mentioned earlier, they can then use these mortgages as collateral for more capital and purchase additional mortgages, etc.
Besides issuing equity or debt, mREITs rely to a great extent on repurchase agreements to raise capital. In fact, 74% of funding for mREITs is via the Repo market.
This type of financing exposes mREITs to specific risks not as relevant to other types of REITs that may use more traditional forms of capital raising.
Repurchase agreements are financial contracts whereby a security is sold to another party, with the agreement to repurchase that security at a future date at a higher price. The difference between the current price and the future price is the implied interest rate.
As I mentioned earlier, the funds received from the repo can be reinvested in additional securities, which can be used as collateral, and the process can theoretically be repeated over and over again. (In reality, the operation doesn't necessarily have to occur sequentially. The mREIT can negotiate with the counterparty a loan of a certain amount, and deliver those securities once purchased.)
mREITs are exposed to some of the same risks that other REITs and other companies are exposed to. In some cases, the direct risk is quite similar, while in others, the risk category is the same but the contributors to risk can be quite varied.
Credit Risks - for example, all REITs are exposed to credit risk. Equity REITs are exposed to the credit risk inherent in the possible default of one of its tenants, while mREITs are exposed to the possibility of non-payment by one or a group of its mortgage borrowers. There is one exception within mREITs, however, and it is applicable to those mREITs that invest partially or entirely in agency mortgages. Agency mortgages are guaranteed by government agencies, such as Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC), or Ginnie Mae, and are essentially risk-free. Therefore, an mREIT is exposed to credit risk only to the extent that it invests in Non-agency securities.
Liquidity Risks - the MBS market is as liquid as the Treasury market so while this risk does exist, it is minimal. The Treasury market is probably the most liquid in the world so I will not go as far as saying that mortgages are as liquid as Treasuries. However, I do want to get the point across that liquidity risk is extremely low. Mortgage backed securities are issued in large denominations and have an active secondary market. With the exception of 2008, when liquidity in the financial markets froze, you can rest assured that this risk is nominal.
Prepayment Risk - this is one of the highest risks faced by the mREITs because this risk could affect mREITs both when prepayment rates are high as well as when they are low.
The risk of high prepayment rates are a result of the economic environment that typically drives prepayments. Prepayments tend to increase during periods when interest rates decline, making it advantageous for homeowners to refinance at lower rates, or incentivizing consumers to sell their home and buy more expensive homes, as the decline in rates increases affordability.
When rates decline and prepayment rates increase, the mREITs suffer in several ways. As rates decline, prepayments accelerate the cash flows while reinvestment opportunities for these proceeds provide lower returns. Conversely, prepayment rates decrease as rates rise, causing a deceleration of cash flows when reinvestment opportunities offer higher returns.
Capital gains and losses are also adversely affected by prepayments. When rates fall, mortgage borrowers refinance at a lower rate, essentially causing the mortgage security to disappear just when the decline in rates increases its value.
Conversely, as interest rates increase, the prepayment rates decline because homeowners remain in their homes longer or forego refinancing. In this case, the reduction in prepayments decreases the value of the mortgages and reduces the cash flow available to be reinvested at the higher rates. The rise in rates also lowers the value of the mortgages held in the books and end up being held longer, essentially increasing capital losses.
Important factors are: the difference between current and new mortgage rates and the age of the mortgage.
The difference between the rates available to refinance and those on the existing securities has a magnified effect on prepayments, up until the refi rate is approximately 2% less than the existing mortgage rate. For example, the relative coupon rates below show ranges from -8 to +8 across the horizontal axis. When the difference between the refi rate and the existing rate on the securities is positive, the prepayment rate, shown on the vertical axis, is basically 0. This makes intuitive sense because there is no incentive for a borrower to refinance if the rate they are paying on their existing mortgage is less than the refi rate available if they were to refinance. As the difference the current rate available on a refi falls below the rate on current held mortgages, the prepayment rate increases, right up until the difference is approximately 2%. Once it reaches a difference of 2%, there is only a modest increase in the level of prepayments.
Effect of relative coupon on prepayment rate
Source: Economic Review
The other relevant factor affecting prepayment rates is the age of the mortgage. As the chart below shows, prepayment rates, shown on the vertical axis, increase as they age from 1-5 years and then prepayment rates decline until reaching a steady state of 0.25% per month.
Source: Economic Review
Mitigation - this risk is difficult to hedge against. Most mREITs with lower prepayment risk invest in either low coupon, HARP, or high LTV loans that are less likely to be refinanced. Low coupon loans are less likely to get refinanced because the rate differential required for a beneficial refi is around 2%. If a loan already has a low coupon, it is not likely that rates will drop 2% below the current rate.
HARP loans are designed to help borrowers refinance their mortgages even if they owe more on their current mortgage than the value of the house. In other words, it helps borrowers that are underwater refinance their mortgage with conventional terms, when under normal circumstances, they wouldn't qualify. Within the fixed income portion of Annaly's portfolio, only 4.3% are subject to HARP, indicating a very low percentage that would qualify for the program.
With the adjustable rate portfolio, the percentage of loans subject to HARP is 67%, but adjustable rate securities comprise only 10% of Annaly's portfolio.
What are Annaly's Prepayment Rates?
Annaly's prepayment rates have been declining since 4Q 2012 from 20% to 7% in the latest quarter and is probably expected to remain at those levels for a few quarters.
Interest Rate Risk
Interest rate risk for mREITs is extremely high. Increases in interest rates reduce the value of the mortgages held in the books, and they also increase the cost of borrowing. Because mREITs borrow over relatively short periods, the interest rates on borrowings can increase much faster than the interest rates on the mortgages they invest in, which would negatively impact their net interest spread.
Mitigation - one way to reduce interest rate risk is by laddering the repos that are entered into. For example, repos can have varying maturities. If all of the repos are 3-month terms and rates go up over a 3-month period, the mREIT will be forced to raise capital at the higher rates for the entire amount of capital needed. If the repos are laddered, borrowing rates can be locked in for longer periods and 'laddered' so that only a portion of the capital is being refinanced during any one period.
As you can see in the chart below, 1/3rd of Annaly's repurchase agreements mature within 30 days, but the rest of the repos are spread out and a full 1/3rd matures in over 120 days, and 16% mature in more than 1 year.
Interest rate swaps
While laddering repos will mitigate the impact of a sharp rise in short-term rates, mREITs also mitigate exposure to interest rates by entering into interest rate swaps. Interest rate swaps are probably the most common form of hedging and is the favored method for Annaly. Interest rate swaps are entered into whereby the mREIT receives floating rate and pays fixed. So when interest rates rise, they will receive higher payments from the swap, mitigating the higher cost of borrowing.
In this case, they will receive 0.2% while paying 2.14% and a weighted average maturity of 5.26 years. You might be wondering why they would enter into a swap to pay a higher rate, right? Paying the higher rate allows management to better predict its financing costs and also benefit from variable rates when rates rise. While on the surface it may not make sense, it allows management to better predict financing costs, particularly when they rely on short-term financing in a rising rate environment.
Annaly risk profile
Finally, most mREITs, including Annaly, American Capital Agency Corp., Armour Residential, and others, provide a picture of the interest rate and spread sensitivity of its portfolio to give investors an idea of the potential impact on the portfolio value due to a sudden change in interest rates.
For Annaly, the estimated change in the value of its portfolio has actually worsened since the 3Q of 2013. For example, a 75 bps increase in the level of interest rates, measured as a parallel shift in the entire curve, would cause the portfolio market value to decrease by 1.7%, which is a 10.6% decrease in NAV. The impact of MBS spread shock is also worse in the 4th quarter relative to 3Q.
Of course, these tables assume no active management of the underlying portfolio.
Things to look for in the May earnings announcement
- Net interest spread - net interest spread increased from 1.07% in 3Q 2013 to 1.43% in 4Q 2013 due primarily to the net amortization of premiums and accretions of discounts. Meanwhile, the cost of funds increased by 0.26%. A further increase in net interest spread may be a strong indication that Annaly is heading in the right direction again.
- Leverage - leverage decreased over the last couple of years and management has indicated that it could begin to increase again. This may be a signal that management is seeing opportunities in the market.
- Repo ladders - as interest rates continue to rise, albeit in an unpredictable fashion, it will be important to understand how the rolling of repos will affect its cost of financing.
- Prepayment rates - prepayment rates have declined by 70% since 4Q 2012 and consensus opinion is that refinancing will level off and decline going forward. If prepayments drop, the only way for Annaly to invest in higher yielding securities is to access more capital and lever up. If a sustained low prepayment rate is combined with a slight increase in leverage, it could be yet another signal from management that the environment has become more favorable.
- Interest rate risk - pay attention to how the portfolio is positioned for a rise in interest rates. The latest quarter's deterioration is nothing to be concerned about but certainly something to watch out for. Rates are going up, it's just that no one knows when or how fast. Just to be safe, you would want Annaly to protect its portfolio value.
Annaly is a volatile investment. It's not for everyone so don't fall into the trap of investing in it solely for the yield without understanding the risks. But you should also not avoid it if you are looking for high yield and can stomach some of the volatility and risks that a rising rate environment may cause.
But what if we looked at mREITs a little differently. For example, what if we viewed mREITs not as equities but as high yield fixed income? While it is technically an equity, an mREIT can sometimes act like a high yield bond. (Note that equity is lower on the capital structure than any fixed income security) It has a high yield, it's volatile, and sometimes it doesn't let me sleep at night. What if you look at it that way? Place it in the proper bucket within your portfolio (with the proper % allocation) and understand the risks that will drive returns. Shouldn't you be able to invest in it with confidence and sleep well at night? I certainly hope so.
Sources: Economic Review, Annaly Investor Presentation, SNL Financial
Disclosure: I am long NLY, AGNC, ARR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.