High Yield In A Slow-Growth World: Mortgage REITs

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 |  Includes: AGNC, CIM, HTS, MFA, NLY
by: Parsimony Investment Research

We believe the 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. 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.

An unintended consequence of the slow recovery has been a Federal Reserve policy that has remained stuck in the mud. Chairman Bernanke has indicated that he will keep rates at exceptionally low levels until mid-2013. With 10-year Treasury yields hovering around 2.0%, this low interest rate policy is hurting savers that are looking for safe and reasonable nominal yields. Bill Gross at PIMCO believes that central bank policy is “picking the pockets of savers.”

That said, many investors have been forced to go up the risk curve in search of yield. Generally speaking, higher-yielding asset classes carry more risk. However, that doesn't necessarily mean that these "high-yield" asset classes should be avoided. High-yield stocks and bonds can be appropriate for even the most conservative investors within the context of the right investment strategy.

As discussed in a previous article, we recommend that investors utilize a barbell investment strategy for speculative, high-yield assets. A barbell strategy is a very simple strategy to implement. The strategy involves investing a high percentage of your portfolio in ultra safe short-term investments (like cash and T-Bills) and the remaining portion in risky assets. Specific asset allocations will vary based on an investor's tolerance for risk.

Three high-yield asset classes that investors should consider are Real Estate Investment Trusts ("REITs"), Master Limited Partnerships ("MLPs"), and high-yield corporate bonds. All three assets classes tend to be relatively stable in a slow growth environment.

This article is the first in a series that will discuss each of these asset classes in more detail, including specific investment recommendations for each class.

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 ("MBS"). REITs electing to 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).

A mortgage REITs' principal business objective is to generate income for distribution to its stockholders from the spread between the interest income received on its mortgage-backed securities and the cost of borrowing to finance its acquisition of mortgage-backed securities. Most mREITs utilize leverage to boost shareholder returns.

As discussed above, the "new normal" of subpar, uneven growth with structurally high unemployment will likely persist for years to come. We believe that this is an ideal environment for mortgage REITs, which benefit from a steep yield curve with low short-term funding costs.

Analyzing Mortgage REITs

Investors should look at several key metrics when comparing and analyzing mortgage REITs, including size (market cap), leverage profile, composition of investments (i.e., Agency vs. Non-Agency and Fixed vs. Floating Rates), and most importantly tenure and strength of the management team. All of these metrics can significantly affect the risk profile of a particular mREIT. The following table compares the key metrics for several of the largest mREITs.

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As shown in the table above, hybrid mREITs, which invest in a mix of agency and non-agency MBS (e.g., CIM and MFA), tend to trade a discount to agency-only mREITs. This is because agency mortgages are guaranteed by government sponsored entities (implying limited credit risk). Conversely, non-agency securities do not carry a similar implied guarantee, making them inherently more risky due to the higher relative credit risk. As such, hybrid mREITs typically deploy less leverage than agency-only mREITs.

mREITs with a high concentration of fixed rate securities (e.g., AGNC and NLY) will likely perform better if interest rates remain low, while a high floating rate concentration (e.g., HTS) is best for investors concerned about rising interest rates in the near future.

Recommendations

We remain the most positive on fixed rate agency mortgage REITs (specifically AGNC and NLY) due to limited credit risk, a relatively steep yield curve, slower expected prepayment speeds, and an accommodative Fed that has a stated plan of maintaining short-term interest rates (biggest risk to mREITs) for nearly two more years (mid-2013). In addition, we believe that the best investment strategy is to own a portfolio of mortgage REITs to diversify your risk. However, we caution investors to watch interest rates and prepayment rates very closely if invested in the space.

Disclosure: I am long AGNC, NLY.