It has been tough to watch the market this past week, let alone mREITs. The losses experienced, the rumors, and the fears promulgated through the news make us question our mREIT holdings. When considering what to do with an mREIT stock it is important to assess:
The composition of the portfolio, whether it is made up of fixed-rate or adjustable rate mortgages and whether they are agency or non-agency backed. Its weighted-average life, which gives you a duration of how long you expect to collect cash (principle) from the security based on certain prepayment rates and market conditions.
Short-term financing sources, their average rate and maturity.
Any hedges the company has in place to protect its financing costs and investment yield.
In this article I will discuss the portfolio composition and the short-term financing policy of American Capital Agency (AGNC), MFA Financial (MFA) and Annaly Capital (NLY), they make up the top five holdings of two mREIT ETFs: the iShares FTSE NAREIT Mortgage REITs Index ETF (REM) and the Van Eck Marker Vectors Mortgage REIT Income ETF (MORT).
|American Capital Agency Corp. (AGNC)||4.76 B||21%||7.5:1||1.01|
|MFA Financial, Inc. (MFA)||2.23 B||15.9%||3.2||0.83|
|Annaly Capital Management, Inc. (NLY)||15.00 B||15.5%||5.7:1||0.97|
American Capital Agency (AGNC) - Assessment: Conservative
American Capital earns income primarily from investing in residential mortgage pass-through securities and collateralized mortgage obligations on a leveraged basis. These are agency backed securities, meaning their principle and interest payments are guaranteed by U.S. Government-sponsored entities, such as Fannie Mae and Freddie Mac.
As of June 30, 2011 its portfolio consisted of 88% fixed-rate mortgage-backed securities and about 12% adjustable-rate securities. This is great for the current environment of low interest rates, because the value of fixed-rate mortgages rises as interest rates fall. The weighted-average life--with an estimated prepayment rate of 10%--of more than 97% of its securities are three years or greater, allowing American Capital’s yield on its portfolio to remain almost unchanged even though Operation Twist lowers long-term interest rates. It is important to note that if prepayment rates rise AGNC would experience losses, not only because the yield on its portfolio would fall but because it has purchased its portfolio at a net premium.
AGNC has diversified its financing sources to secure buying power. As of June 30, 2011 AGNC had financing arrangements with 26 financial institutions and did not have an amount at risk with any counterparty greater than 10% of its stockholders’ equity.
American Capital is a conservative company. Its portfolio is made up of mostly fixed-rate mortgages with a weighted average life of three years or greater. It has managed to diversify its short term financing sources mitigating risks of a credit crunch. If Europe stabilizes its banking system, American Capital should not have much problems maintaining a healthy dividend. On Sept. 13, AGNC announced a dividend of $1.40, the same rate it has paid over the past eight quarters.
MFA Financial Inc. (MFA) - Assessment: Risky
MFA Financial invests in agency and non-agency hybrid and ARM (adjustable rate mortgage) securities. Hybrid mortgage loans have interest rates that are fixed for a specified period and, thereafter, generally adjust annually to an increment over a pre-determined interest rate index.
As of June 30, 2011, about 81.6%, of MFA's MBS portfolio was in its contractual fixed-rate period or were fixed-rate MBS and about 18.4%, was in its contractual adjustable-rate period, or were floating rate MBS. This is good news, because the yield on the portfolio will be effected less when interest rates decrease, at the same time the value of the securities will rise, increasing book value. A thing of concern however, is that 35.2% of their portfolio is invested in Non-Agency MBS of which about 89% is rated CCC or lower. Non-Agency securities are not guaranteed by a government agency, so they carry a risk of default. Nonetheless, MFA notes that Non-Agency MBS are trading below par values giving its portfolio higher yields and the ability to benefit from increased prepayment rates.
MFA's policy on financing is to enter into repurchase agreements with multiple counterparties with a maximum loan from any lender of no more than three times the Company’s stockholders’ equity. Like other mREITs, its short-term loans have various maturities, about 61% were repurchase agreements that had maturities of 30 day or less, and about 30.5% had maturities of between 30 days and three months. This gives some reassurance that the company has enough time to seek out financing sources if liquidity dries up, however, liquidity is not a big problem for MFA since it is flush with cash. As of June 30, 2011 it had $503.2 million of cash and cash equivalents and $510.8 million of unpledged Agency MBS. This positions them to take advantage of investment opportunities that might arise.
MFA Financial is more on the risky side because it owns non-agency securities. This could prove to be a positive however, since the non-agency mortgages were bought at a discount allowing it to benefit if prepayment rates rise. This maybe the case, because MFA recently announced an unchanged dividend of $0.25.
Annaly Capital (NLY) - Assessment: Conservative
Annaly Capital primarily invests in high quality Agency backed securities. Its policy allows it to have at least 75% of its portfolio made up of triple AAA, high quality mortgages and the remainder made up of mortgages and assets that are rated BBB or higher. Presently as of June 30, 2011 Annaly's portfolio is almost entirely made up of AAA rated agency backed securities.
About 90% of Annaly's portfolio is made up of fixed-rate securities, and 10% adjustable rate. This is a positive because as rates decrease, the portfolio will rise in value and maintain its yield. About 74% of those securities have a weighted average life that ranges between one and five years, and 25% have a weighted average life equal to fiver years or more. This is positive because it will decrease the effect Operation Twist will have on the yield of its portfolio, since Annaly can hold on to most of its securities until maturity which is well after June 2012, the date when Operation Twist is expected to end. Annaly's portfolio is stable except that the aggregate premium exceeds the aggregate discount, meaning that if prepayment rates rise Annaly will face losses.
By acquiring only AAA rated agency-backed securities, Annaly is able to get financing at attractive terms, because mREITs use the mortgages in their portfolio as collateral in their financing deals. To diversify its counterparty risk, Annaly has maintained credit relationships with many high quality lenders and has utilized self-imposed limits on the amount borrowed from any one lender.
Annaly Capital recently announced a dividend of $0.60 a share which is about 8% lower than the previous quarter's dividend of $.65 a share. This drop can be explained by increased borrowing costs due to turmoil in European debt markets, and maybe a higher than expected prepayment rate which Annaly is prone to. The relative modesty of the drop is reassuring because it shows that Annaly can maintain itself in the face of tremendous market uncertainties. Once Europe gets its finances in order, Annaly can provide higher dividends due to lower borrowing costs and higher leverage.
The mREITs discussed above are well positioned to withstand the affects of Operation Twist. Most of the mortgages owned by these mREITs will mature after Operation Twist is over on June 2012, so the yield of their portfolio should remain approximately the same. MFA Financial can even benefit from Operation Twist if prepayment rates rise, because a big part of its portfolio is made up of securities that were purchased at a discount.
The companies I discussed are not experiencing volatility because of the effects of Operation Twist on their portfolio. I believe the effects of the Operation are well known and priced in to a certain extent. The volatility is coming from fear of a credit crunch created by the European debt crisis that would drive up borrowing costs for mREITs. This fear might subside soon as European governments unite to tackle their problems. The recent pledge by the French and German officials to protect eurozone banks is a step in the right direction. With the Fed committed to keeping rates low until mid 2013, patient investors who can withstand the volatility will benefit.
As for the stocks themselves:
Annaly Capital is the most conservative of the three. It has the largest market cap, its portfolio is made up of mostly fixed rate AAA agency mortgage-backed securities and its low leverage of 5.7:1 allows it to handle volatility and take advantage of investment opportunities. Its main downside is its exposure to prepayment risk. It recently declared a dividend of $0.60, which was lower than the previous quarter.
American Capital Agency Corp. is also conservative. Its portfolio is made up of agency backed securities and it has a prudent short-term financing policy. This company also suffers from exposure to prepayment risk. What makes it less conservative than Annaly is its higher leverage of 7.5:1. It declared a dividend of $1.40, in line with the previous quarter.
MFA Financial is risky because a part of its portfolio is made up of non-agency securities that have a rating of CCC or lower, however, it has proven itself by maintaining the second quarter dividend payout of $0.25. The company is positioned to benefit if prepayment rates rise, and it's low leverage, high cash balance and unpledged mortgages give it the firepower to take advantage of new opportunities.
Disclosure: I am long NLY.