Investors should consider a key technical factor when buying mortgage real estate investment trusts (mREITs). The constant prepayment rate (CPR) will play a key role in determining the level of mREIT's quarterly dividends. The higher the CPR, all other aspects remaining the same, the lower the mREIT's dividend will be. This issue makes American Capital Agency Corp. (AGNC) a standout stock to buy for its dividend and book value per share maintenance. This article highlights why the constant prepayment rate benefits American Capital Agency's earnings, dividends, and book value.
Agency mREITs earn money by borrowing funds at short term rates. This is usually done via a repurchase agreement with a 3rd party. The repurchase costs are fairly low. The agency mREIT then invests the proceeds in higher yielding government sponsored entity (GSE) mortgage backed securities. The difference between the longer duration yield and the shorter duration borrowing cost yield is the net yield curve.
Agency mREITs Leverage
Most agency mREITs leverage the net yield spread by 6x to 8x. The mortgage securities serve as collateral. The mREITs are extended leverage from a Primary Dealer. GSE securities are guaranteed by the federal government.
In my personal opinion, I would like to see agency mREITs take advantage of the favorable market conditions and ramp the leverage up. Due to the policy risk and prepayment risk, this may not be practical. In theory, however, increasing the leverage could offset some of the decreasing net yield curve.
Constant Prepayment Rate (CPR)
Rising Constant Prepayment Rate
The constant prepayment rate reflects the percentage of principal that is prepaid over a period of time on an annualized basis. Interest rates can rise and fall. If interest rates are rising, fewer home owners will refinance to a higher interest rate.
Decreasing Constant Prepayment Rate
If interest rates are decreasing, then the refinancing rate typically increases as home owners want a lower monthly payment. Thus, a decreasing interest rate environment increases the mREIT's constant prepayment rate.
An mREIT, such as American Capital Agency Corp. , wants to contain their mortgage backed securities portfolio from a high constant prepayment rate. Minimizing the negative effects of prepayment risk will provide American Capital Agency with higher dividends, a higher book value per share, and outperformance versus its mREIT peers.
Net Yield Curve
The net yield curve has taken a bit hit since December 1st. Per the below U.S. Treasury site, the reader can note the drastic interest rate decline in the 10 year, 20 year, and 30 year Treasury Bond yields.
The impact of the decrease in bond yields carries over to the agency mortgage backed securities. The net yield curve is compressing, which results in lower dividends. Foreign countries are buying Treasury bonds for safety. The euro sovereign debt crisis continues to increase flow into the U.S. Treasury Bond market where the funds are guaranteed.
In addition, the Federal Reserve is anticipated to begin a Quantitative Easing 3 program. The dollar impact could range from $545 billion to $800 billion. The Federal Reserve wants to decrease interest rates for mortgage home owners. A negative impact is risk averse investors are now forced to seek riskier asset classes instead of holding Treasury Bonds for their interest income.
ARMOUR Residential REIT (ARR)
ARMOUR Residential, for the 3rd quarter, had a constant prepayment rate of 12.40%. The company did not provide any guidance on future estimated constant prepayment rates. This would be based on management's interpretation of its mortgage backed security portfolio.
American Capital Agency Corp. (AGNC)
American Capital Agency has paid a net premium to its mortgage backed security portfolio. As interest rates decrease, bonds increase above par value. For a simple example, assume a $100 Fannie Mae GSE bond has a 4% coupon rate for a 15 year duration. If interest rates go down to 2.8%, then the Fannie Mae GSE Bond increases from $100 to $106. The bond has unique characteristics pertaining to prepayment risk, and policy risk. If this $106 is prepaid early, then American Capital Agency takes a hit on initially paying a premium to the bond's par value. Since the bond was not held until maturity, the mREIT experiences a negative financial write down on the $6 premium.
American Capital Agency can hedge on interest rate risk and use derivatives to hedge many GSE bond components. What American Capital Agency specializes in is preparing the portfolio for prepayment risk.
If the actual prepayment experienced differs from American Capital Agency's estimate of prepayments, then the company will be required to make an adjustment to the amortization or accretion of premiums and discounts that would have an impact on future income. Per the above slide, investors can note management's focus upon prepayment risk.
American Capital Agency had an actual constant prepayment rate of 8% for the 3rd quarter. The 8% rate is the lowest I have found amongst the mREIT industry. The company has anticipated an increased level of 13% for future periods.
Annaly Capital Management, Inc. (NLY)
Annaly Capital is the largest market cap mREIT. The company experienced an 18% constant prepayment rate for the 3rd quarter. This is significantly higher than American Capital Agency's 8% constant prepayment rate, although all mortgage portfolios have unique characteristics such as mortgage duration til maturity.
Anworth Mortgage Asset Corporation (ANH)
Anworth experienced a 28.0% constant prepayment rate for the third quarter ending September 30th. This included, however, agency mortgage backed securities and non agency securities. In addition the company recovered $830,000 in previous write down on non agency securities.
CYS Investments (CYS)
CYS Investments' constant prepayment rate was 12.6% for the 3rd quarter. CYS Investments can hold collateralized mortgage obligations, which can impact the constant prepayment rate. For example, collateralized mortgage obligation can be subject to greater prepayment risks than whole pool agency residential mortgage backed securities.
CYS Investments did state their October 2011 agency residential mortgage backed securities constant prepayment rate was 19.8%. Management stated they believe this rate will increase in the remaining months of the 4th quarter.
Hatteras had an annualized 28.8% prepayment rate through the September 30th quarter. Hatteras has an estimated prepayment rate of 10%, of 4.1 years, as of the end of the 3rd quarter. Keep in mind each mREIT has a variety of unique hedging tools, and a variety of types of security ownership. Hatteras focuses upon adjustable rate and hybrid adjustable rate mortgage backed securities.
Credit Default Swaps
On a positive note, the current Credit Default Swaps for Italy and Spain have gone down and remained fairly consistent in recent days. The reader can note that Greece is on the down and out, and waiting for the shipping industry to return. Italy and Spain are considered too big to fail, and are my key focus.
Investors should buy the best run agency mREIT. I believe Gary Kain, CEO of American Capital Agency, has proven he has positioned the company to minimize the constant prepayment rate compared to its peers. The third quarter's 8% constant prepayment rate illustrates the effectiveness that the company had versus its peers. This is not to suggest that every mREIT had an identical mortgage security portfolio, but to illustrate the company's complete focus on minimizing the constant prepayment rate.
The above slide illustrates America Capital Agency's December 1st views on its prepayment risk containment. I recommend buying American Capital Agency today at current valuations. The stock went ex-dividend today. The company may submit a secondary offering due to its effective business model. This will be done only if the deal is accretive to current shareholders' book value per share.