Agency mortgage REITs performed very badly in 2013 as interest rates rose. That caused Agency RMBS to lose book value. The interest rate of the 10 year US Treasury peaked at 3.03% on December 31, 2013. It closed at 2.72% on March 31, 2014; and it has since descended further to 2.52% as of this writing on June 2, 2014. What this kind of action typically means for Agency mortgage REITs is a narrowing of the net interest rate spread (lower core profits) and an increase in book value of the Agency RMBS (as interest rates go down Agency RMBS values usually go up). Of course, the design of the portfolio and the types and amounts of hedges can change the expected results. Considerable turnover in the portfolio will also tend to deflate results.
Let's look at a few primarily Agency mortgage REITs' performance in Q1 2014.
- CYS Investments (NYSE:CYS) produced a total economic return of 8.2%.
- American Capital Agency Corp (NASDAQ:AGNC) produced a 5.1% total economic return.
- ARMOUR Residential REIT (NYSE:ARR) produced a 1.68% total economic return.
- Western Asset Mortgage Capital (NYSE:WMC) produced a -2.69% total economic return.
Total economic return consists of the dividend plus any increase or decrease in book value for the quarter.
CYS Investments seems to have put in the best Q1 2014 performance. What did it do right? Its portfolio as of March 31, 2014 is below.
It has a large proportion of 15 year fixed rate Agency RMBS (about 48% of its portfolio). Plus it has about 15% of its portfolio in Agency Hybrid ARMs. Its net interest rate spread for this portfolio in Q1 2014 was 1.89% with a leverage of 6.32x. The hedges for 15 year fixed rate Agency RMBS are much cheaper than hedges for 30 year Agency RMBS, so CYS saved money there. Plus the 15 year fixed rate Agency RMBS present a much smaller risk of losses in the case of an interest rate increase, even without hedges. CYS also has very low coupon rates at a weighted average rate of 3.13% on its 15 year fixed rate Agency RMBS and 3.96% on its 30 year fixed rate Agency RMBS. I actually don't like this. The low coupon securities present a substantial extension risk; and if interest rates go up significantly, CYS will likely get hurt badly if it has to exchange these securities for higher coupon securities in a rising rate environment. However, in the current falling rate environment, these same securities may be among the most profitable.
Further CYS had only 73% of its portfolio notionally hedged. This means that CYS would profit more from increased RMBS book values due to a decrease in interest rates. Q2 2014 so far appears to be another "falling interest rate" quarter. This will likely mean that CYS will have another great quarter in Q2 2014. The management team of CYS seems to believe in their strategy. Insiders have purchased 126,110 shares of stock (+11.5%) in the last six months. In contrast institutions have sold -7.11% of their CYS stock. They are perhaps worried about CYS's performance if interest rates rise. CYS pays a 13.97% annual dividend. CYS at a June 2, 2014 closing price of $9.16 is trading at a discount to its March 31, 2014 book value of $9.68 per share.
AGNC put in a great performance in Q1 2014 also. Its portfolio as of March 31, 204 is below.
AGNC also has a large proportion of 15 year fixed rate Agency RMBS -- approximately 50% of its portfolio. However, it has no ARMs, which are longer term less interest rate sensitive. Its net interest rate spread was a 46 bps lower at 1.43% (or 1.59% with dollar roll income) with leverage of 7.6x at Q1 2014 end (7.2x during the quarter). AGNC is saving money on hedges by having a larger proportion of 15 year fixed rate Agency RMBS. AGNC is also insuring itself against interest rises a bit with these less sensitive, shorted dated RMBS. Further AGNC's extension risk is much lower than CYS' due to AGNC's much higher weighted average coupon rate of 3.72% for its 15 year fixed rate Agency RMBS and 4.38% coupon rate for its 30 year fixed rate Agency RMBS. Another difference is that AGNC was hedged 94% notionally as of March 31, 2014. This is more than it was hedged as of December 31, 2013 (86%). That means that AGNC will see lower book value gains than CYS in Q2 if interest rates stay as low as they have so far fallen (or go lower). However, if investors see a spurt in interest rates in June 2014 (the last month of Q2 2014), AGNC should lose less in book value than CYS on its non-ARM Agency RMBS. I am deliberately not estimating changes in CYS' Hybrid ARMs for the reason that I don't have enough information at this time; and AGNC has no comparable item. AGNC is playing it relatively safe. Thus it may be a good play for someone who does not want to pay too much attention to their portfolio. Plus it is seeing both insider buying (+6.8%) in the last six months and institutional buying (+7.47%) in the prior quarter to the present quarter. AGNC pays a 10.96% annual dividend. AGNC at a closing price June 2, 2014 of $23.71 is trading at a discount to its March 31, 2014 book value of $24.49.
The portfolio as of April 15, 2014 is below.
As investors can see ARR got rid of all of its longer dated Agency RMBS. It sold all of its 20-25 year and 25-30 year fixed rate Agency RMBS. These amounted to 44.22% of its portfolio on January 9, 2014. Just the action of exchanging (selling and buying) this much of its portfolio had to be expensive. It accounts for some of ARR's poorer performance in Q1 2014. ARR did lose -$0.08 in book value in the quarter, although its total economic return was still a positive +1.68% on the quarter. Surprisingly this led to an increase in net interest margin from 1.60% in Q4 2013 to 1.82% in Q1 2014. Part of this was probably the lower expense of the hedges for the shorter dated Agency RMBS. Part was probably due to the overall decrease in notional value of assets hedged from 97.8% as of January 10, 2014 to 91.5% as of April 15, 2014. However, part of the book value loss ($4.75 to $4.67 at the end of Q1 2014) was likely due to the higher notional amount of hedges at the beginning of Q1 2014, which lost value as the interest rates declined during Q1 2014.
With interest rates lower in Q2 2014 from Q1 end 2014 by about -20 bps as of June 2, 2014, ARR should see a good amount of build up in book value in Q2 (lower derivatives losses). If the interest rates rise, ARR should still be reasonably well protected against interest rate increases. Plus it should not have the added expense it incurred in Q1 2014 of selling all of its longer dated Agency RMBS.
In sum ARR's performance in Q1 was sub-par compared to CYS and AGNC; but it has positioned itself well for the future. Most of its Hybrid ARMs are short time to reset ARMs with an average time to reset of 9 months. ARR should be able to simply hold these without long-term worries, especially since they comprise only 1.21% of its portfolio as of April 15, 2014. Both insiders (+1%) and institutional investors (+6.16%) have been buying ARR. This is a good sign; and it attests to the "safer" portfolio that ARR now has. ARR pays a 13.79% annual dividend. ARMOUR Residential REIT is trading at a slight discount to its March 31, 2014 book value of $4.67 at a June 2, 2014 close of $4.35 per share.
Western Asset Mortgage Capital produced a -2.69% total economic return, yet it has the highest dividend at 18.55% annually. Its portfolio as of March 31, 2014 is below.
The slow stochastic sub chart is near overbought levels. The main chart unlike the other stocks does not yet show a firm bottom. To me the state of the portfolio also indicates a lot of downside risk on interest rate rises. Even with the 18.55% dividend, I would stay away from WMC at this time. The -2.69% Q1 2014 total economic return is another reason to beware of WMC. It may do all right in Q2 2014, but I would worry a lot about its longer-term outlook to want to buy WMC at this time. Plus it is the sole stock that is trading at a premium to its March 31, 2014 book value of $14.19. Admittedly the company says that its May 8, 2014 book value is probably closer to $15 per share. However, the amount this is moving around scares me. The portfolio makeup scares me.
In sum CYS, AGNC, and ARR are all buys at this time. The situation may change; but they appear to be stable good yielders at this point. WMC seems to be popular. One is inclined to think many are being attracted by its high yield (18.55% annually). However, given its underperformance in terms of total economic return, the dividend appears to be a red herring; and investors should think twice before buying WMC. It appears that too much can go wrong.
NOTE: Some of the fundamental fiscal information above is from Yahoo Finance.
Good Luck Trading.
Overall AGNC appears to be the safest of the above stocks while retaining a good yield. CYS and ARR both have their good points. WMC is the highest yielding stock; but it appears to be unwilling to change. Alternatively it may be betting too much on one direction of interest rates. This seems too risky for me; but for those who agree with WMC's direction, they may still wish to bet on this high yielding stock.
The two year chart of CYS may provide direction for a trade.
The slow stochastic sub chart shows that CYS is overbought. The main chart shows that CYS has bottomed. It now appears to be in an uptrend. Given that it is trading at a discount to its March 31, 2014 book value of $9.68, CYS probably still has further upside. However, investors may wish to wait for a pullback before they try to get in. Averaging in is an alternative.
The two year chart of AGNC may provide direction for a trade.
The slow stochastic sub chart shows that AGNC is overbought. The main chart shows that AGNC is in a reasonably strong uptrend. Since AGNC is trading at a discount to its March 31, 2014 book value of $24.49, it probably has more upside.
The two year chart of ARR may provide direction for a trade.
The slow stochastic sub chart is at overbought levels. The main chart shows that ARR is in a slight uptrend. Since ARR is trading at a discount to its March 31, 2014 book value of $4.35, it probably has more upside.
The two year chart of WMC may provide direction for a trade.
The portfolio above shows that WMC is not following the lead of the other Agency mortgage REITs. It has a large amount of 30 year fixed rate Agency RMBS. They comprise 67.82% of the total Agency RMBS portfolio, although only 51.21% of the entire portfolio. Plus the only other fixed rate Agency RMBS in the portfolio are 20 year RMBS. This makes for a portfolio that will be expensive to hedge against interest rate rises; and it will be much more susceptible to book value losses on interest rate rises irrespective of hedges. It has a weighted average net interest rate spread of 1.80% and a leverage of 8.2x (including net TBA positions).
Overall there are comparably too many possible negative scenarios for this stock. Yes, it pays a great dividend of 18.55%; but it is too unsafe. When other like companies saw their book values increase (or in ARR's case decrease slightly), WMC saw a large book value decrease from $15.27 on December 31, 2013 to $14.19 per share on March 31, 2014. This is unacceptable to me as an investor. I further do not like the large amount of longer dated Agency RMBS, especially when virtually all the other players are moving to shorter dated Agency RMBS. Further, WMC is trading at a slight premium to its March 31, 2014 book value of $14.19 at $14.45 as of the close on June 2, 2014.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AGNC, ARR, CYS over the next 72 hours. 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.