There seems to be more discussion of the prospect and timing of a turn in Federal Reserve policy. From an investor's perspective, it is important to develop a sense of how this will impact different securities. It is well known that long-term fixed rate bonds tend to lose value as prevailing interest rates increase, and an initial assumption might be made that bond-like equities which are attractive primarily because of dividend yield would behave the same way. Two categories of equities I have followed closely bear scrutiny in this regard. Both Business Development Companies (BDCs) and Agency Mortgage REITs are "bond-like" in that their primary assets are debt instruments and they are bought primarily by yield oriented investors.
Before going any further, I should note that I am not in the camp of investors who believe that a federal funds rate increase is imminent. The economy is still fragile, the powers that be at the Federal Reserve believe that "core" inflation is low, and financial institutions are still in the healing process. However, there is a sharp division of opinion on this issue and, more fundamentally, it is clear that rates will eventually have to increase. It is also the case that, once it becomes crystal clear that rates will rise, then the impact of the increase will likely be already "priced in" to various securities.
There are two ways to think about this issue. The first is to analyze the portfolios of relevant companies and to try to determine how an increase in rates will affect profitability. I am going to try to do this in more detail in future articles but some general observations can be made. Agency Mortgage REITs tend to be highly leveraged and, thus, would be adversely affected by an increase in borrowing costs. It is possible to hedge against such an impact but the cost of hedging may increase as the risk of a rate increase becomes more apparent. BDCs, on the other hand, are much more lightly leveraged (some have no net debt at all) and thus are not as impacted by increases in the rate of interest on their own debt. Within each category, there are variations in asset mix. Some BDCs have a high percentage of their assets in floating rate business loans and thus will earn more interest as rates increase. Agency mortgage REITs tend to have a higher percentage of their assets in pools of fixed rate mortgages. As noted above, there are variations within each group and I plan to drill down on this in future articles.
At any rate, the lower level of borrowings and the higher percentage of floating rate assets would lead one to suspect that BDCs might perform better than mortgage REITs in an environment of rising interest rates. This leads to the second approach to the issue which is examination of historical evidence. On June 30, 2004, after holding the federal funds rate at 1% for an extended period of time, the Federal Reserve raised that rate to 1.25%. It then proceeded to raise the rate repeatedly over a two year period of time, finishing with a rate increase from 5 to 5.25% on June 29, 2006. This period of time serves as a useful "test period" to examine the performance of various investments.
There is a difficulty in examining the performance of BDCs and Agency Mortgage REITs during this period. Many of the entities that are now in the market did not exist at the beginning of this "test period" or, if they did, were investing "into" the rising rate environment because they had just begun operations. Thus, the number of companies we can examine is limited. I have included MVC Capital (MVC), which is primarily an equity holding BDC and thus might be expected to perform differently from debt holding BDCs, because of this difficulty.
Before going any further, I should also add that history never really repeats itself and the next rising rate scenario is sure to have its own unique and perplexing characteristics.
At any rate, I have taken several companies and analyzed their performance during this "test period." After each company, I have listed the stock price at the close of the week ending June 28, 2004 (right before the rate increases started), the stock price at the close of the week of July 3, 2006, (right after the last rate increase in the series) and the low weekly close for the stock during the "test period" as well as the week in which that low occurred.
- A. American Capital, Ltd. (ACAS) - 28.09; 33.66; 28.02(7/6/04)
- B. MCG Capital Corporation (MCGC) - 15.13; 15.85; 14.06(4/3/06)
- C. MVC Capital (MVC) - 9.59; 12.50; 9.00(12/13/04)
2. Agency Mortgage REITs
- A. Annaly Capital Management (NLY) - 17.32; 12.60; 11.23(12/19/05)
- B. Capstead Mortgage (CMO) - 13.40; 7.47; 5.77(12/05/05)
- C. Anworth Mortgage Asset (ANH) - 12.00; 8.01; 7.27(12/19/05)
The historical evidence seems to confirm what the structural analysis suggests: BDCs outperformed Agency Mortgage REITs during this test period by a healthy margin. Indeed, BDC stocks tended to rise in value during the test period while Agency Mortgage REITs got crushed.
Several points must be noted, however. This is simply an analysis of share prices and does not include dividend income. Agency Mortgage REITs tend to have much higher dividend yields than BDCs and the total return would not have been as lopsided in favor of the BDCs. Secondly, the performance of the two sectors after the "test period" was very different. The BDCs experienced deterioration of their loan portfolios, non-performing loans and leverage problems. In some cases, they stopped paying dividends entirely. In almost all cases, stock price declined precipitously. Agency Mortgage REITs weathered the financial crisis much more robustly. Finally, all of these companies are aware of this issue and are presumably deploying strategies to cope with rising rates should they occur. This topic is certain to be prominent in all quarterly conference calls as we go forward.
I think that dividend investors have to be aware of this history in putting together their portfolios. BDCs will tend to do better if the only problem is rising rates but BDCs own much more risky loans than Agency Mortgage REITs. If rising rates lead to financial stress, BDCs will be exposed to the kind of meltdown in share prices that they faced in 2008-09. There is simply no alternative to investor due diligence. Investors cannot look at a stock in either of these sectors as if it were a "black box" simply spitting out quarterly checks until the end of time.
Each of these companies has a story and a structure, and changes in interest rates and in the macroeconomic environment may lead the dividends to be reduced or suspended and may lead the share price to decline. That said, a well-designed portfolio including BDCs, Mortgage REITS and dividend paying large-cap stocks is still one of the best long term strategies for a yield oriented investor.