Flat Prepayments Are Bullish For Mortgage REITs

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

Investors in search of yield have flocked to mortgage REITs due to the Federal Reserve's interest rate policy. Mortgage REITs take advantage of a tax status to invest in mortgage related real estate assets. REITs can invest in both physical real estate assets and real-estate related securities like mortgage-backed securities. REITs electing the take advantage of the tax status must distribute 90% of taxable income as dividends.

A mortgage REIT's principal business objective is to generate income for distribution to its stockholders from the spread between the interest income received on its mortgage-backed securities and the cost of borrowing to finance its acquisition of mortgage-backed securities. In addition, most mortgage REITs utilize significant leverage to boost shareholder returns.

Mortgage REIT investors must assess interest rate risk and prepayment risk. Mortgage REITs are highly levered investment vehicles that are sensitive to rises in short-term in interest rates. With a borrow short, lend long business model a rise in short-term rates can impact profitability. In addition, mortgage refinancing damage securities that trade for more than face value by returning principal faster at par and curbing interest.

According to eMBS prepayment rates have stabilized at a higher level over the last few months. The chart below outlines the increase in prepayment rates for agency mortgage back securities.

click to enlarge image

Click to enlarge

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 closely monitor 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.

Annaly Capital Management, Inc. (NYSE:NLY) - Fixed Rate Agency Focused REIT

  • Price to Book Value: 1.0x
  • Dividend Yield: 13.7%
  • Market Capitalization: $16.1 billion
  • Leverage: 5.2x

American Capital Agency (NASDAQ:AGNC) - Fixed Rate Agency Focused REIT

  • Price to Book Value: 1.1x
  • Dividend Yield: 16.3%
  • Market Capitalization: $6.8 billion
  • Leverage: 7.7x

MFA Financial (NYSE:MFA) - Hybrid REIT (Agency and Non-Agency)

  • Price to Book Value: 1.1x
  • Dividend Yield: 13.6%
  • Market Capitalization: $2.6 billion
  • Leverage: 3.2x

Two Harbors (NYSE:TWO) - Hybrid REIT (Agency and Non-Agency)

  • Price to Book Value: 1.1x
  • Dividend Yield: 15.7%
  • Market Capitalization: $2.1 billion
  • Leverage: 4.5x

Hatteras Financial (NYSE:HTS) - Floating Rate Agency Focused REIT

  • Price to Book Value: 1.1x
  • Dividend Yield: 12.6%
  • Market Capitalization: $2.2 billion
  • Leverage: 6.7x

I am bullish on the hybrid mortgage REITs due to their ability to invest in both below par non-agency MBS as well as agency MBS. Hybrid mortgage managers can move in and out of the different asset classes finding the best value for shareholders.

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