Love Them Or Hate Them, Mortgage REITs Deliver

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Includes: AGNC, CMO, NLY
by: Nikita Smeshko, CFA

Summary

Mortgage REITs have received a great deal of undeserved negative publicity.

The sector has traditionally delivered strong returns that are uncorrelated with traditional asset classes.

Current discounts to book value lead to a buying opportunity for “pure play” mortgage REITs.

Stories about the death of the mortgage REIT (mREIT) are a dime a dozen on Seeking Alpha and other financial media channels. These stories typically attribute a flattening of the yield curve and an increase in interest rates as events that will put an end to the earnings power of mREITs.

This analysis does not take into account the fact that mREITs already hedge interest rate exposure and maintain minimal duration gaps, risk mitigation strategies inherent in their business model. "Pure play" mREITs, those with minimal credit exposure, have a long history of effectively navigating a variety of interest rate environments, including those with flat and inverted yield curves.

While the recent mortgage REIT universe is large, there are only a small handful of mREITs that have been in business for more than 10 years. The two most well known examples are Annaly Capital (NYSE:NLY) and Capstead Mortgage Corporation (NYSE:CMO). Annaly has been in business since 1997, while Capstead has been in business since 1987. The earnings potential of a well run mREIT is easily seen when you plot the total return index of these two REITs versus the S&P 500 since their inception.

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Total return growth of Annaly versus the S&P 500 from the first day that Annaly started trading through the end of 2015.

This is an annualized return of 10.5% for Annaly versus 3.7% for the S&P 500. Annaly is much more volatile than the S&P 500 with an annualized standard deviation of 32.0% versus 20.4% for the S&P 500.

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Total return growth of Capstead versus the S&P 500 from the first day that Capstead started trading through the end of 2015.

This is an annualized return of 11.3% for Capstead versus 7.4% for the S&P 500. Capstead is much more volatile than the S&P 500 with an annualized standard deviation of 38.6% versus 18.2% for the S&P 500. Both of these mREITs exhibit considerable volatility, but make up for it with strong returns.

Pure play mREITs create double-digit returns through moderate leverage. This leverage has a magnifying effect on book value when there are price movements in the underlying collateral. When the book value shifts, the stock usually shifts to fall into close proximity of the book value. On occasion, sentiment can create further volatility in the stock and move the stock in one direction or another away from the book value of the assets.

While mREITs are a volatile investment, that volatility is not strongly correlated with either stocks or bonds. mREIT volatility comes from changes in mortgage spreads as well as from changes in the shape of the yield curve. Both of those factors are only partially correlated to either stock or bond returns.

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I'm refraining from using a mortgage REIT Index because I cannot find an index that does not have considerable exposure to REITs that have a large amount of credit exposure.

mREITs are also only loosely correlated with each other due to the variety of assets that exist in the mortgage market and the varying investment strategies of each mREIT. The direction of each segment of the mortgage market is extremely difficult to accurately forecast with any reasonable level of consistency, while the portfolios of these companies may change materially from quarter to quarter. This makes it difficult to select just one mREIT investment at a time. Instead, a basket approach to the sector makes more sense.

The sector as a whole is trading at considerable discounts to their underlying book value, making them even more valuable opportunities for investors. There are three mREITs that stand out for their risk management, run divergent investment strategies, have considerable discounts to their book value, and are pure play mREITs. These REITs are Annaly Capital, American Capital Agency Corp. (NASDAQ: AGNC), and Capstead Mortgage Corporation.

Annaly Capital is currently trading at a 23% discount to their underlying book value. The company invests primarily in generic fixed rate mortgage pools and is moderately active in trading their underlying assets. The company has a strong operating history.

American Capital is currently trading at a 28% discount to their underlying book value. They invest primarily in fixed rate mortgage pools, but a large percentage of their holdings are in mortgages that have a story attached to them. These mortgages typically cost more to purchase than a generic mortgage, but are expected to be more stable in the long run, making them easier to hedge. American Capital is also very active in trading their assets and will move their balance sheet considerably quarter over quarter.

Capstead is currently trading at a 23% discount to their underlying book value. The company has been in business since 1985 and is the oldest publicly traded mREIT. The company is 100% invested in floating rate agency mortgages. Their entire portfolio requires very little interest rate hedging since the majority of it is invested in securities that reset their interest rate on a yearly basis. They rarely trade their securities for capital gains, which has turned their legacy portfolio into a valuable asset that cannot be replicated by external investors.

These three companies have all seen large price declines in recent years as investors, wary of interest rate hikes, have run for the hills. The underlying assets of the mREITs have also adjusted from unrealistic valuations that existed when the Federal Reserve was adding agency mortgages to their balance sheet. With these stumbling blocks behind them, the companies now trade at levels that make them cheap relative to their future earnings potential.

Disclosure: I am/we are long NLY, AGNC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.