In this near-zero interest rate environment, many investors feel obligated to seek out alternative yields that may supplement a lack of cash flow through risk free returns of cash and Treasury investments. One controversial yet 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 RMBS types. Non-agency RMBSs are generally higher yielding than agency RMBSs, but also present the risk of borrower default.
Default 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. Subprime largely imploded in 2007 and 2008, with defaults across all types subsequently occurring. Many have estimated that a significant wave of defaults will hit the Alt-A and Option ARM categories if and when interest rates begin to rise.
Most hybrid mREITs now hold large and growing positions in agency RMBSs. Since the Subprime crisis, fewer non-agency mortgages have been issued, and hybrid mREITs have accumulated larger positions in agency debt out of necessity. Additionally, many have opted to diversify into agency-backed paper in order to reduce their income-stream and portfolio value volatility.
Below are recent performance rates and current annual dividend 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).
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Non-agency RMBS paper valuations declined significantly during 2011, bringing down most of these hybrid mREITs. So far in 2012, after several months of declining prices, these REITs averaged 16.59% equity appreciation.
Some of the recent strength by these mREITs is based upon the January Federal Reserve low-rate policy extension, as well as potential mortgage refinancing initiatives by the government. The exact effect of such refinancing is still speculative, but refinancing and prepayment is likely a substantially preferable alternative to these REITs 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, income requirements and total portfolio of investments.
Disclosure: I am long CIM.
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.