With interest rate promises from the Federal Reserve and negative real returns from Treasuries, investors are looking at mortgage REITs for yield. These companies generate and distribute income from the spread between mortgage-backed securities (MBS) interest income and borrowing costs to purchase the portfolio. Low interest rates, all but guaranteed by the Fed to 2014, will help to boost earnings and ensure a healthy spread between borrowing and lending.
Extremely low betas offer protection from market swings and are a good way to hedge your view of an over-priced market. These stocks are not highly correlated with the rest of the market because of their sensitivity to other factors like interest rates and prepayment rates. As such, they can provide a high amount of diversification for your portfolio. Mortgage REITs do not usually see much price appreciation but will be a solid income portion of your portfolio to balance against growth stocks.
The potential for many of these companies was summed up for me recently by Udo Onwuachi, a CMO evaluator:
Quantitative easing and liquidity injections by the Fed have pushed yields way down on many fixed-income products, but agency CMOs still offer some upside potential because of the breakdown in the prepayment models. Despite lower rates, many are unable to refinance meaning investors are still collecting higher interest payments but borrowing much lower.
Since REITs must pay out most of their earnings, they must continually go back to the market for capital. This means taking on debt or issuing shares and can cause problems for current investors. Many of the mortgage REITs found themselves in uncertain times when the mortgage and credit markets froze up in 2008. Credit markets have improved over the last couple of years as consumers and businesses deleverage and improve their overall balance sheets.
One caveat is that these companies could come under pressure if new government initiatives allow masses of underwater homeowners to refinance their mortgages. This would undermine prepayment models on which the MBS and CMO assets are valued. The mortgage REITs would see large amounts of assets paid off early and would have to reinvest the proceeds in cheaper mortgages. While this is still a risk, the strengthening housing market and election year politics may mean that new legislation is watered down.
Annaly Capital Management (NLY) owns and manages a portfolio of agency mortgage-backed securities, including collateralized mortgage obligations. The shares trade for 6.8 times trailing earnings and pay a yield of about 13.5% on an annualized basis. Since Annaly invests most of its assets in agency-backed mortgage debt, credit risk is not a factor. The shares trade at a beta of just 0.22 relative to the market.
A 10 year chart of Annaly shows the idiosyncratic nature of these investments. The share price has mostly traded in a range between $16 and $20 with a couple of periods of weakness during the financial crisis. The company has trimmed back its debt-to-equity ratio recently to around 5.4 times from 6.7 times at the end of 2010. While the lower amount of leverage has strengthened the company's balance sheet, it may affect near-term earnings and distributions. Overall, distributions should remain attractive and may improve when the company returns to a more historic level of leverage. Expectations are for a decrease in reported earnings from $2.40 in 2011 to around $1.94 in 2012. Lower earnings will reduce the distributions but they should stay well above a 10% yield on the current share price.
Invesco Mortgage Capital (IVR) invests in residential and commercial mortgage-backed securities. Like Annaly, almost all loans are backed by federal agencies and carry payment guarantees. Shares trade for 5.1 times trailing earnings and pay a yield of 17.5% on the current share price. Shares are a little more highly correlated at a beta of 0.89 against the general market.
Earnings are expected to come down next year to around $2.61 per share compared to $3.45 for the last four quarters. The could bring distributions down but would still be a yield over 13.3% on the current share price at a distribution payout of 90% of earnings per share. The company has total leverage around 6.4 times, slightly down from over the most recent quarter.
Disclosure: I am long NLY.
