Residential mortgages are generally divided into two primary subdivisions: mortgages insured by federal agencies and those without agency backing. Hybrid mortgage REITs hold both types of RMBS. Non-agency RMBSs are generally higher yielding than agency RMBSs, but also present the risk of borrower default.
Default risk on such non-agency backed mortgages is substantial enough to rate a significant portion of non-agency paper as junk. Within the world of non-agency mortgages, there are four main categories: Prime, Alternative-A (Alt-A), Option Adjustable Rate Mortgages (Option ARMs) and Subprime. The subprime RMBSs largely imploded in 2007 and 2008, with some defaults across all other 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. Many have opted to diversify into agency-backed paper in order to reduce their income-stream and portfolio value volatility. Additionally, since the Subprime crisis, few non-agency mortgages have been issued, and the lack of non-agency paper has forced many hybrid mREITs to accumulate larger positions of agency paper out of necessity.
Below are recent performance rates and current annual dividend rates for five mortgage REITs that are largely invested in non-agency RMBS paper: Chimera Investment (CIM), Invesco Mortgage Capital (IVR), MFA Financial (MFA), Redwood Trust (RWT) and Two Harbors Investment (TWO).
And below is a 2012-to-date performance comparison chart for these hybrid mREITs:
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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 16.1% equity appreciation, or more than these mREITs now yield.
Some of the initial strength by these mREITs was fortified by the Federal Reserve's low-rate policy extension in late January, as well as potential mortgage refinancing initiatives the government has discussed. The exact effect of such refinancing is still speculative, but refinancing and prepayment are generally substantially preferable alternatives to 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.
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.