- Mortgage REITs are trading at 10% discounts to book value.
- Mortgage REITs are yielding 12% with dividends cut to sustainable levels.
- 5 names for your basket: AGNC, CYS, TWO, MFA, and AMTG. Yield, diversity, and the ability to thrive in rising and falling rate and economic conditions.
- Preferred stock is a new and growing segment for mREIT investors; they offer competitive yields to the reduced dividends in the sector, while offering a more senior capital position.
The second-biggest surprise of 2014 - aside from President James Heller surviving a missile strike on TV's "24" - has been the revival in the Mortgage REIT stocks. After a disastrous 2013, when the sector was blindsided by Ben Bernanke's May 2013 Taper Tantrum, mREITs saw the 10-year Treasury rise from 1.6% to 3% in 5 months, a near-doubling, even though still low by historical levels. This was one of the fastest and most dramatic rises in long-term interest rates in U.S. history. By comparison, when the Fed lost control of rates in the late-1970s as inflation soared, the 10-year and 30-year Treasury bonds both took about 18 months for their yields to rise by about 50% (500 bp. at those levels). As we have talked about before, the mathematics of duration and negative convexity are quantifiable variables that we know will have less negative impact going forward, even if bearish rate forecasts materialize and yields move higher. In fact, most mREITs are being priced right now for a 3.50% 10-year Treasury (see below).
The revival in the sector is not unexpected if one had correctly forecast the trajectory of interest rates in 2014. The 10-year Treasury bond came into 2014 right at 3%, and expectations were near-universal that rates would soar to the mid-3%'s by year-end, possibly into the 4% range. I was not as bearish at that time, because I felt that the consensus was leaning too strongly in favor of higher rates and the last time the 10-Year approached 4% (in early-2011), the market stumbled. So I felt that corrective forces from the bond market itself, a weak stock market, or soothing Fed talk would prevent another 100+ bp. rise in the 10-year Treasury like we saw in 2013.
Another fear that has not materialized has been a widening of MBS spreads to Treasuries, known as the MBS basis. Even if rates are flat, if MBS yields rise as demand for MBS paper declines, you can have rising MBS yields, which are even worse than rising Treasury yields because of the extreme difficulty in hedging basis risk (swaps and collars can reduce pure interest rate risk). As the Federal budget deficit has been cut by 2/3rds helping Treasury yields, the supply of MBS has also dwindled as higher rates have impacted housing demand for mortgages. When you take into account the Fed re-investing paydowns of MBS principal and interest, you actually have a pretty balanced supply-and-demand picture for MBS in 2014 YTD. The great fear for mREIT investors entering 2014 was that Fed tapering would reduce demand and lead to a widening of spreads on top of rising Treasury yields, a lethal 1-2 punch of higher rates and wider spreads.
Because liquidations of GSE bonds have exceeded issuance, agency MBS shrank in Q1 2014 and has continued to run negative or barely positive in recent months. This is why tapering hasn't led to rising rates (for both Treasuries and MBS), because the drop in demand from the Fed is more than offset by reductions in supply (as well as demand from other buyers like Central Banks, PIMCO, insurance companies, etc.).
Let's get a 30,000-foot overview of where the mREITs are at right now:
One sell-side firm provides intra-quarter book value estimates, but the numbers are highly volatile and just guesstimates. Note that the estimate for American Capital Agency (NASDAQ:AGNC) is almost $2 higher than the trailing book value.
What's the downside if rates move higher? This matrix will give you an idea of how vulnerable current portfolios are to higher rates. If you believe, as I do, that the average mREIT, over time, should trade more or less at book value (ignoring any persistent value added by skilled management teams), then current mREITs are discounting a rise in rates close to 3.50%. Which would mean even if we go there, to sell at a similar discount, the stocks would likely have to discount a rise in the 10-Year to 4.25%-4.50%.
Some of the smaller names like Oaks Financial (NYSE:OAKS), ZAIS Financial (NYSE:ZFC), and ARMOUR Residential REIT (NYSE:ARR) are trading at 85% or less of book value. However, I would STRONGLY advise not chasing the cheapest stocks based on price-to-book. While there are times when you don't want to pay up for premiums or higher P/Bs (since essentially, every mREIT is backed by similar MBS assets), there are times when you don't want to skimp on quality management and strategies, either. If rates rise and/or the MBS basis widens, you want managements already incorporating those scenarios into their playbook and/or willing to trade into the new environment. Stick with quality until the sector has the wind at their back and not in their face.
What names to buy now? I think this is a time to be selective and cautious, but mREITs can definitely be added at current levels, and especially so if/when rates rise closer to 3.00%-3.25% on the 10-year Treasury (I doubt rates go higher). Remember my past articles about "buying a basket" of both agency and hybrid mREITs. You are buying this sector for dividends, not gambling on who will get lucky guessing the direction of interest rates and generating outsized stock gains. The sector still has headwinds against it, but they are more akin to a light breeze and not 2013's gale winds.
With that in mind, here are 2 agency mREITs and 3 hybrid mREITs to fill that portfolio basket:
American Capital Agency: The bellwether of the group, AGNC had a rough 2013, as even its trading expertise, management, and past record of nailing rate and MBS moves did not help it navigate the treacherous 2013 landscape. But the company has shifted more of its agency MBS portfolio to 20-year and 15-year paper. A bit less yield, but much shorter duration than 30-year mortgages and also much easier to hedge. With a $0.65 quarterly dividend maintained now for 3 quarters, the stock appears capable of sustaining that payout for a dividend yield of 11.3%.
Like other mREITS, American Capital has been hamstrung in that it was prevented from taking advantage of the higher rates once its stock prices fell below book value, preventing accretive equity offerings. The solution? Issuing preferred stock. Not as large or as liquid a market as for common stock, but every little bit of capital helps. Below is a representative listing of preferred shares. All trade in $25 face value increments and offer good yields relative to the common for the more risk-averse:
Remember, preferred stock in a liquidation or bankruptcy has a higher priority than common stock (but not debt). So basically, you'd have to see the common stock go to zero before full recovery of the preferred was imperiled.
CYS Investments (NYSE:CYS): CYS is the counterpart to AGNC for agency mREIT investors who want a bit more aggressive play in the sector. CYS has positioned its portfolio for a range-bound interest rate market (2.50%-3.00% on the 10-year Treasury), but believes that GSE MBS will weaken relative to treasuries as spreads (that basis again!) widen. If spreads remain tight and rates fall, CYS will lag the group. With a $0.32 quarterly dividend yielding 14.6%, CYS offers one of the higher yields in the mREIT sector.
CYS's agency portfolio consists of 15-year fixed MBS (48%), 20-year fixed MBS (1%), 30-year fixed MBS (25%), hybrid ARM MBS (15%), and US Treasury (12%) securities. Again, we see another mREIT distancing itself from a heavy concentration in 30-year mortgage paper. The yield advantage in 30-year MBS is not enough to take on the duration risks, and the hedging costs are also much higher. With a double-digit yield and modest leverage at 6.5x, shareholders are already well-compensated, and avoiding additional risk is prudent.
TWO Harbors Investment (NYSE:TWO): The hot trend in mREITS is to have exposure to mortgage servicing rights (MSRs), the steady recurring fees that one gets for handling mortgages. Their main attraction is their negative duration - inversely correlated to interest rates - which complements a credit or agency MBS portfolio. Unfortunately, to get scale in the MSR world, you need a servicing platform with established relationships with quality, known lenders (subprime and NINJA lenders need not apply). MSRs are one of the few - if only - ways to hedge MBS basis spread risk.
With its established network of 30 lenders, TWO is the front-runner among the mREITs for positioning for MSRs and whole loans in the future, especially once mortgage volume picks up. In the meantime, the quarterly dividend of $0.26 should not have more than few cents of downside, if even that materializes. Assuming capital deployment accelerates and the earnings increase from a potential doubling of MSRs, combined with cheap funding from a subsidiary's FHLB membership, the 10% dividend yield looks secure for this hybrid mREIT. Investors also get the benefit of one of the savviest MBS and real estate players in Pine River Capital Management.
MFA Financial (NYSE:MFA): MFA Financial continues to set the standard for the hybrid mREITs. With a portfolio comprised of 57% agency and 43% non-agency MBS, MFA is perfectly balanced to benefit from most interest rate environments. In addition, 2/3rds of MFA's agency MBS are comprised of hybrid ARMs. While hybrid ARMs can suffer bouts of illiquidity and lag rising rates - June of 2013 a perfect example, as a few large sellers overwhelmed the market - they are still much lower-duration than fixed rate MBS.
MFA wrote down credit-sensitive assets in 2008-09, and added to its portfolio with some earlier vintage subprime and credit-sensitive assets. The biggest gains since 2009 have come in these "junk" MBS assets, much as the best investments in bonds have come from high-yield "junk" bonds. As a wise bond veteran once told me, "There are no bad bonds, only bad prices." MFA got great prices on some of its holdings; even bonds worth only 40 cents on the dollar are a lottery payout if you paid 15 cents on the dollar. With large amounts of credit reserves, any reversal of those credit losses will boost MFA's book value and lead to sustainably higher quarterly dividends or more special dividends.
Apollo Residential Mortgage (NYSE:AMTG): Although not a small-cap, at under $1 billion in market capitalization, AMTG is a name I would normally pass on in favor of a similarly-managed but larger-cap mREIT. However, AMTG drastically cut leverage in 2013, repositioned the portfolio from agency to credit-sensitive MBS, and has more aggressively moved into other credit-sensitive assets. As of Q1 2014, the portfolio was 60% agency MBS, 37% non-agency, and 3% whole loans. AMTG initiated a pilot program, whereby it is involved in financing starter homes in the southeastern U.S. It's a novel way to gain access to rising real estate values instead of chasing non-agency MBS, but it bears watching (houses are less liquid than securities). The current program is only a few million dollars, so AMTG will watch the results carefully before deploying more capital into this segment of whole loans/real estate.
A 40% cut in the dividend payout last year brought a more achievable run rate of $0.40, which provides a 9.6% yield. In fact, Apollo recently raised the dividend to $0.42, so the floor on the dividend looks to be set, given current market conditions and AMTG's massive de-leveraging. While a sub-10% yield is not something mREIT investors are used to chasing, it appears sustainable, and in a low-rate environment, is still attractive. And should rates move higher, AMTG has the balance sheet to withstand book value erosion and defend the dividend much stronger than in 2012-13.
2013 showed that mortgage REITs are not for the faint of heart. They have their strengths, but those same strengths can be turned into Kryptonite weaknesses if the underlying conditions (interest rates or credit conditions) reverse. Keep a keen eye on the 10-year Treasury bond yield and any accelerated timetable for Janet Yellen's 1st Fed Funds hike of her tenure; Non-Farm Payroll numbers in the high-200k's or above 300k/month would be a red flag for the bond market. The effects of the Supplementary Leverage Ratio on repo markets needs to be watched. And if liquidity is the hallmark of mortgage REITs, the addition of more illiquid assets like whole loans or actual homes by the hybrid mREIT bears watching.
That said, remember we are dealing with financial entities that are leveraged between 4-8x, compared to U.S. banks at about 12-15x and European banks at 15-25x. mREITs can liquidate and go to 100% cash within a few days, a few weeks tops; a bank would need several quarters, if not years, to liquidate all her branches, ATM machines, loans, and real estate. The sector is also running at near-record lows for leverage, at about 7x, while trading at just under book value. A decade ago, the sector traded at 9-11x leverage and P/B levels of 125%-150%.
Reduced rewards compared to the days of yesteryear with high-teens dividend yields? Yes, but reduced risks, too. Compared to the S&P 500 at all-time highs yielding 2% and all types of bonds trading at super-rich valuations, mREITs offer a decent value proposition in the current rate environment. Expect to bank mid-to-high single-digit dividend yields in H2 2014, and add in some modest price appreciation to close the discount to book value, and you can easily see a 10% return on average for the sector for the balance of 2014. Volatility in the U.S. stock market or European, Asian, or Mideast events would likely lead to stronger outperformance.
The volatile action going forward should be in repeat episodes of "24", not the mREIT sector. After 2013, investors have earned the respite.
Additional disclosure: The author has online and managed portfolios under his control which have positions in the stocks listed above.