Agency REITs: Cream Of The mREIT Crop

Includes: AGNC, ANH, CMO, HTS, NLY
by: Parsimony Investment Research

Mortgage REITs have had a halo of uncertainty since September when the Securities and Exchange Commission sent shockwaves through the mortgage REIT market seeking comment regarding the treatment of asset-backed issuers and mortgage REITs.

The SEC document provides background on the history of mortgage REIT regulations, raises questions on the industry’s legal and tax status and, most importantly for investors, casts a light on the use of leverage throughout the industry.

The SEC is questioning whether agency focused mortgage REITs, which primarily invest in “agency” mortgage backed securities that are akin to a bond fund, should be regulated similarly to other bond funds. Translation: lower leverage. A forced deleveraging from 7.0x leverage to 1.5x leverage would put pressure on the mortgage backed securities market.

While we have trimmed our overall allocation of mortgage REITs, we think agency REITs continue to be a suitable investment for investors seeking good risk-adjusted yield. 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.

Agency Mortgage REITs provide yield hungry investors access to strong dividend yields. These securities typically perform well in low interest rate environments with steep yield curves. We think they provide investors a hedge against heavy cash and short-term bond portfolios in the event interest rates stay low for an exceptionally long period of time.

Note: We recently wrote a more detailed article advocating mortgage REITs in a low growth environment (here).

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 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).

Tenure and Diversification

Given the risk to portfolios in volatile interest rate environments, we believe that investors should focus on those managers that have a proven track record of managing their portfolio through various rate cycles. In addition, we think it is prudent to diversify mortgage REIT holdings as managers deploy different strategies within the complex.

Below is a list of agency-focused mortgage REITs.

Agency REITs with bias toward Fixed Rate Mix

  • Annaly Capital Managment (NYSE:NLY)
  • American Capital Agency (NASDAQ:AGNC)

Agency REITs with bias toward Floating Rate Mix

  • Anworth Mortgage Asset Corp. (NYSE:ANH)
  • Capstead Mortgage Corp. (NYSE:CMO)
  • Hatteras Financial Corp. (NYSE:HTS)

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We believe that due to the structural headwinds in the U.S. economy, the Federal Reserve will keep things on hold for an exceptionally long period of time. That said, we believe that current valuations are attractive for agency-focused mortgage REITs.

In general, we think interest rates will remain low for the foreseeable future (next 12-24 months). As such, we believe REITs (particularly agency-focused REITs) offer investors an extremely compelling risk/reward profile. However, we caution investors to watch interest rates, prepayment rates, and leverage levels very closely if invested in the space.

Disclosure: I am long NLY, AGNC.