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We have been bullish on mortgage REITs due to what we believe is a strong underlying macro economic and political environment for the asset class. Ultimately we believe that monetary policy will remain loose and interest rates will remain low, which will benefit mortgage REITs.

Mortgage REIT Overview

Mortgage REITs take advantage of a tax status to invest in mortgage-related real estate assets. REITs can invest in both physical real estate assets and real-estate related securities like mortgage backed securities. REITs electing the take advantage of the tax status must distribute 90% of taxable income as dividends. The primary advantage of using the REIT tax designation is that these companies do not pay state or federal corporate taxes on dividends paid to investors. Instead, the taxes are paid by the REIT equity holders (investors).

Comparison of Large Mortgage REITs

Yield in a Slow-Growth World

We believe U.S. is facing long-term structural issues that will lead to a prolonged period of uneven, subpar growth. The unemployment and housing issues that we face will take years, not quarters, to resolve. The U.S. has overinvested in housing while under-investing in its people. Politicians and economists will debate whether we are in or going into recession, but 1%-2% real growth will feel like recession for most Americans, and will not improve unemployment levels.

Political Deadlock

As witnessed through the debt ceiling debate, the political environment has become highly charged with little willingness to compromise. The left is focused on Keynesian stimulus while the right is focused on Austrian austerity. We think the political stalemate will lead to limited policy changes and force the hand of monetary policy.

We believe this backdrop is extremely bullish for mortgage REITs. Mortgage REITs, which benefit from a steep yield curve with low short-term funding costs, provide investors a yield haven in a slow growth world.

Monetary Policy

Federal Reserve chairman Ben Bernanke is a student of the Great Depression. We believe Chairman Bernanke’s academic background influences his policy decisions. Unlike many other central banks, the Federal Reserve has a dual mandate focused on price stability and full employment. Many central banks focus solely on price stability.

The introduction of full employment creates complexity for the Federal Reserve. As mentioned earlier, we believe the U.S. faces a structural unemployment issue that can only be solved through retraining and education. Lower interest rates will unlikely solve the issue, but the Federal Reserve will continue to feel the pressure to “do something.” The 24-hour news cycle world that we live in will put increasing political pressure on the Federal Reserve to solve the ills of the economy, which we believe will translate into low interest rates. After a sharp fall in the equity markets, economists and Wall Street are already clamoring for QE3.

Interest Rate Spread and Prepayment Trends

Mortgage REITs earn money by borrowing short and lending long. As long as the yield curve remains steep and short-term rates remain low, mortgage REITs should continue to provide strong dividend yields to investors.

In addition to interest rate spreads, investors should also monitor an REIT's constant prepayment rate (CPR). Prepayment speeds determine the timing of principle cash flows coming back to the MBS investor. The faster the prepayment rate, the quicker cash flows are paid back to the bond investor, and therefore the shorter the life of the fixed income investment. Conversely, when prepay speeds slow down, the average life of the bond's cash flows are extended, which is good for mortgage investors.

Due to higher down payment requirements and lower conforming loan limits, we believe that prepayment risk will remain subdued. Despite aggressive statements by the Fed to maintain rates at low levels for prolonged periods, the refinance market may remain challenged due to conservative appraisals and increased mortgage lending standards.

Offset to Ultra-Low Yields

Mortgage REITs can provide investors a hedge against ultra low yields on short-term Treasuries and certificates of deposit. We suggest that investors that maintain healthy cash balances invest a portion of their portfolio in high-yielding mortgage REITs.

Stick with the Industry Veterans, and Diversify

We recommend that income investors add industry veterans such as Annaly Capital Management (NLY) and MFA Financial (MFA) to their portfolios. NLY and MFA were both formed in 1997, and the management teams have a proven track record of successfully managing their portfolios through various interest rate cycles. In addition, NLY and MFA are both internally managed, which oftentimes limit governance issues.

Mortgage REITs are highly levered investment vehicles that need to manage interest risk, prepayment risk, credit risk (non agency securities) and liquidity. The mortgage REIT landscape is littered with failures. REITs that did not make it through the cycle or had their dividend eliminated include Thornburg Mortgage, New Century Financial, Apex Mortgage, and Carlyle Capital. As such, we think that cautious, conservative investors should allocate the bulk of their REIT investment with industry stalwarts. However, we continue to believe that the best strategy for investing in this space is to own a portfolio of mortgage REITs to diversify your risk.

Source: Making The Case For Mortgage REITs