In the recent and still ongoing low-interest rate environment, many investors have sought out high-yielding fixed income alternatives to supplement portfolios. One popular option has been agency mortgage REITs.
Mortgage REITs keep portfolios of mortgage backed securities. Agency mortgage REITs manage portfolios composed of residential mortgage backed securities that are insured by federal agencies. Because government agencies underwrite the mortgages and issue these RMBSs, the paper comes with an agency backing and an implied U.S. government backing.
As borrowers defaulted over the last few years, the agencies have been required to pay and/or buy out the defaulting obligations. The government continues to fund these agencies, and the vast majority of current residential mortgage activity is composed of these types of mortgages.
Prepayment buying of mortgages, whether through borrower refinancing or due to agency buyout after a default, will have a volatile and affect upon a mREIT's quarterly income, yield, book value and the spread that the mREIT can achieve between its borrowing costs and investment return.
Each prepayment essentially cashes the holder out of a position, requiring them to find a replacement investment. In this low interest rate environment, it has often been the case that these mREITs were forced into lower yielding paper. Nonetheless, prepayment is considerably preferable to an actual default.
Below, I have provided recent performance rates for five reasonably liquid and high yielding Agency Mortgage REITs: American Capital Agency Corp. (NASDAQ:AGNC), Annaly Capital Management, Inc. (NLY), Capstead Mortgage Corp (NYSE:CMO), Cypress Sharpridge Investments (NYSE:CYS), and Hatteras Financial Corp (NYSE:HTS). I have provided one-week, one-month, 2012-to-date and 1-year equity performance rates, as well as each REIT's yield. The performance rates do not include dividends paid.
So far this year, these mREITs have appreciated an average of 5.69 percent. These agency mREITs also have a present average yield of 14.1 percent, meaning they paid out a quarterly dividend of about 3.5 percent during the first quarter.
One major and growing concern to agency mREITs is that rising interest rates could hurt the value of the RMBS assets held by these mREITs. Moreover, since most of these mREITs leverage their assets in order to multiply the return, the portfolio's value could suffer multiplied losses if rates rise. Agency mREITs now have leverage rates between about five and eight times their equity, with many increasing their leverage over the last few quarters and/or decreasing their dividend payouts.
Because of the risks associated with agency mREIT leverage and potential peaking of Treasury valuations, exposure to the asset class should be limited to a reasonable percentage of a portfolio, based upon your risk profile, time-horizon, income needs and other investments. Additionally, most REIT dividends are taxed as regular income and not at the lower corporate dividend rate, making them substantially better performing investments when held within tax deferred or exempt accounts.
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.