In this low interest rate environment, many investors feel obligated to seek out large yields that can supplement the lack of cash-flow being generated through the risk free returns of cash and Treasury investments. One controversial, yet an incredibly high-yielding investment is found within non-agency and/or hybrid mortgage REITs.
Residential mortgages are primarily divided into two subdivisions: mortgages insured by federal agencies and those without agency backing. Hybrid mortgage REITs hold both agency and non-agency residential mortgage backed securities. Non-agency RMBSs are generally considerably higher yielding than agency paper, but also present the risk associated with borrower default. Such risk is substantial enough to rate a significant portion of non-agency backed debt as junk. There are four primary types of non-agency mortgages: Prime, Alternative-A (Alt-A), Option Adjustable Rate Mortgages (Option ARMs) and Subprime.
Most hybrid mREITs now hold large and growing positions in agency RMBSs. Since the subprime crisis, fewer new non-agency mortgages have been issued, and hybrid mREITs have accumulated larger positions in agency debt out of necessity. Additionally, many opted to diversify into agency-backed paper in order to reduce income-stream and portfolio value volatility.
Below are recent performance rates for five mortgage REITs that are largely invested in non-agency RMBS paper, though not necessarily exclusively or to a majority, depending on their current portfolio mix: Chimera Investment (NYSE:CIM), Invesco Mortgage Capital (NYSE:IVR), MFA Financial (NYSE:MFA), Redwood Trust (NYSE:RWT) and Two Harbors Investment (NYSE:TWO). In addition to their recent equity performance rates and current annual dividend rates:And below is a 2012-to-date performance comparison chart for these REITs:
Non-agency RMBS paper valuations declined significantly during 2011, bringing down most of these hybrid mREITs. So far in 2012, these REITs averaged 11.86 percent equity appreciation, after several months of declining prices. Last week was broadly negative for these REITs, largely on the back of poor Q4 reports from some agency only mREITs.
These mREITs and RMBS may get a boost from potential mortgage refinancing, but the effects of such a program are still unclear and speculative. It could work out that a decent portion of the non-agency mortgages will be refinanced and converted into agency-backed debt, which would likely work out well for these REITs. The exact effect of such refinancing is still speculative, but refinancing and prepayment is probably a substantially preferable alternative for creditors and debtors than default.
Under the current tax laws, mREIT dividends are taxed as ordinary income, and not at the lower corporate dividend rate. Since mREIT dividends are taxed as income, they are considered substantially better performing investments when held within tax deferred or exempt accounts.
Mortgage REITs continue to be one of the highest-yielding options available to income-oriented investors. Nonetheless, due to their significant risk profile, exposure to non-agency RBMS should be limited to a reasonable percentage of a high-risk portfolio, based upon an investor's total risk profile, time-horizon and other investments.
Disclaimer: This article is intended to be informative and should not be construed as personalized advice as it does not take into account your specific situation or objectives.