Hybrid Mortgage REITs Benefit From Rising Prepayments

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Includes: AGNC, MFA, NLY, TWO
by: Bear Fight

As the Federal Reserve has driven down short-term interest rates to ultra-low levels, investors have flocked to mortgage REITs in search of yield. I believe investors should focus on hybrid mortgage REITs as opposed to agency mortgage REITs. Agency REITs including Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) invest in government guaranteed mortgage backed securities. Agency REITs carry limited credit risk as securities are guaranteed by government sponsored entities. Agency REITs are subject to interest rate and refinance risk. As opposed to agency REITs, hybrid REITs invest in both agency and non-agency securities. Hybrid REIT managers have the flexibility to move between agency and non-agency securities to find the best risk/reward for shareholders.

Investors should investigate MFA Financial, Inc. (NYSE:MFA) and Two Harbors Investment Corporation (NYSE:TWO). MFA is an internally managed REIT and its management team believes there are significant opportunities within the non-agency RMBS space. Since January 2000, MFA has provided investors with annual returns of 14.5%, far outpacing the S&P500.

Prepayment Risk

A key risk for mortgage REITs is prepayment risk. As rates decline, borrowers refinance loans into lower rates, which impact mortgage REIT earnings. After the credit collapse, hybrid mortgage REITs including MFA purchased non-agency mortgages at discounts to par. In the most recent reporting period MFA owned over $4 billion of non-agency MBS at an average cost of $0.73. As refinancing on these securities increases, MFA realizes more than its average cost. The table outlines the increase in yield when speeds increase. MFA management believes the company can generate 7.3% loss adjusted annual unlevered yields on non-agency securities.

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Conversely, agency mortgage REITs including Annaly and American Capital Agency which have an average cost of over $1.00 can experience loss on securities as refinancing increase. If an investor pays $1.04 for a face value security of $1.00 and the security is refinanced the investor will lose $0.04.

Hybrid Mortgage REITs

Two Harbors Investment Corp.

  • Market Capitalization: $1.7 billion
  • Dividend Yield: 16.1%
  • Price to Book Value: 1.1x
  • Leverage: 4.5x

MFA Financial, Inc.

  • Market Capitalization: $2.7 billion
  • Dividend Yield: 13.3%
  • Price to Book Value: 1.0x
  • Leverage 3.5x

Agency Mortgage REITs

Annaly Capital Management

  • Market Capitalization: $16.0 billion
  • Dividend Yield: 13.8%
  • Price to Book Value: 1.0x
  • Leverage: 5.4x

American Capital Agency

  • Market Capitalization: $6.7 billion
  • Dividend Yield: 16.7%
  • Price to Book Value: 1.1x
  • Leverage: 7.6x

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.