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Some mortgages are agency-backed, which means that the mortgages were issued and/or guaranteed by a quasi-government agency such as Fannie Mae (OTCQB:FNMA) or Freddie Mac (OTCQB:FMCC). These agency mortgages are considered virtually risk free because the agencies are supposed to step-in and make payments to the lender on behalf of the non-paying borrower that they backed. These agencies can also choose to buy out the mortgage, and they often do so in the event of a borrower’s default continuing for several months.

Mortgages backed by government agencies carry the least default risk because of that agency guarantee. Nonetheless, with that reduced risk these mortgages also carry the lower yields. As a result, most REITs that specialize in agency backed mortgage securities (Agency mREITs) use a high level of leverage to increase the yield. These REITs make money off the spread or margin that they can achieve between the interest rate on the money they borrow and the rate paid by the mortgage paper. For example, if a company can borrow at 3% and buy paper that yields 5%, the spread is 2%. The level of leverage used by the REIT then multiplies that spread payout.

Differences do exist amongst mREITs housing agency-backed mortgages, such as the level leverage used, the composition of fixed versus adjustable rate mortgages and other methods used, if any, to hedge interest rate risk. Below is a list of seven mREITs that have a majority or exclusive agency mortgage portfolio, as well as their most recently reported approximate levels of fixed versus adjustable/floating rate paper and share yield.

Click to enlarge:

When interest rates change, fixed interest bearing paper’s value will change in an inverse manner to the rate change. The value of floating rate paper that tracks interest rate changes is less affected by those subsequent changes. Preferences for fixed versus floating rates vary depending on where rates are and the assumptions made over future rates. Floating paper demand increases when the market anticipates rising interest rates, and fixed rates are usually sought when interest rates are dropping. The market largely anticipates coming interest rate increases, though some disagree, with varying predictions as to the speed that such changes may come.

Many mREITs also attempt to hedge exposure to rate changes in a desire to maintain, improve and/or mitigate damage to their spread. For example, a company may buy treasury puts or use another similar strategy that may act as an insurance policy. Such hedging techniques will often lessen present returns in an effort to help the mREIT maintain a reasonably smooth spread level and rate of return as the market changes.
Source: A Breakdown of Fixed vs. Floating Paper for 7 Agency mREITs