Investors have flocked to high yielding securities including mortgage REITs due to the Federal Reserve's interest rate policy. In a search for yield investors should remain cautious on mortgage REITs due to rising prepayment risks.
Mortgage refinancing damage securities that trade for more than face value by returning principal faster at par and curbing interest. Agency mortgage REITs including Annaly Capital Management (NLY) and American Capital Agency (AGNC) have accumulated securities above par. According to Barclays Capital, the expansion of the Home Affordable Refinance Program urged by President Barack Obama is set to boost speeds by 1 or 2 percentage points each month.
At current mortgage rates, about 95 percent of the $2.8 trillion of 30-year loans packaged into Fannie Mae (FNMA.OB) and Freddie Mac (FMCC.OB) securities stand to gain from refinancing based on typical closing costs, according to JPMorgan analysts led by Brian Ye.
Agency mortgage REIT investors should be aware of high conditional prepayment rates. Prepayment rates ended the year near 2011 highs as mortgage rates plummet to historical lows. While the government is intervening in the mortgage market, higher coupon securities remain vulnerable to higher prepayment speeds.
Mortgage REITs including Annaly Capital Management and American Capital Agency invest in agency mortgage backed securities issued by Fannie Mae, Freddie Mac, and Ginne Mae. Securities from these agencies carry an implicit guarantee backed by the U.S. government. Due to the lack of inherent credit risk, agency mortgage REIT investors need to focus on interest rate risk and prepayment risk.
Interest Rate Risk
Due a weak economic outlook and stubbornly high unemployment rates, interest rates will likely remain low for quite some time. Any future increases in interest rates will likely be well telegraphed by the Federal Reserve and beyond 2014.
Prepayment Risks
While higher interest rates are unlikely to pose a real risk in the next few years, investors should beware of prepayment speeds. Mortgage REIT investors should focus on conditional prepayment rates (CPR) to monitor the health and dividend potential for mortgage REITs. The CPR reflects the percentage of principal that is prepaid over a period of time on an annualized basis.
As CPRs increase, the company will have to invest in securities with lower coupons, which will hurt earnings. Mortgage REITs are highly levered investment vehicles, which employ significant leverage to generate yields.
According to eMBS prepayment rates have been rising over the last three months. The chart below outlines the increase in prepayment rates for agency mortgage back securities. Investors have been pointing to rising prepayments for rationale as to why certain agency REITs have cut their dividends in the most recent quarter. American Capital and Annaly both saw rising prepayments in the latest quarter.
(Click to enlarge)
Agency REITs with bias toward Fixed Rate Mix
Annaly Capital Management, Inc.
- Price to Book: 1.0x
- Dividend Yield: 13.3%
- Leverage: 5.5x
American Capital Agency
- Price to Book: 1.05x
- Dividend Yield: 16.8%
- Leverage: 7.9x
Agency REITs with bias toward Floating Rate Mix
Anworth Mortgage Asset (ANH)
- Price to Book: 0.94x
- Dividend Yield: 12.8%
- Leverage: 8.5x
Capstead Mortgage (CMO)
- Price to Book: 1.1x
- Dividend Yield: 12.9%
- Leverage: 8.2x
Hatteras Financial (HTS)
- Price to Book: 1.02x
- Dividend Yield: 12.9%
- Leverage: 6.7x
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
