Recent Performance Review Of 5 High-Yield Hybrid Mortgage REITs

Includes: CIM, IVR, MFA, RWT, TWO
by: Zvi Bar

Hybrid mortgage REITs hold both residential mortgage backed securities with and without agency insurance. Agency-backed RMBS paper is deemed by many to have virtually no default risk, due to federal agency backing, but provides a low yield like treasuries, though slightly higher. Non-agency RMBSs are often considerably higher yielding than agency RMBSs, but carry with them the risk of borrower default. While agency-backed paper gets a rating commensurate with the nation's implied guarantee, a large portion of non-agency paper is rated as junk.

Among non-agency mortgages, there are four main categories: (1) Prime; (2) Alternative-A (Alt-A); (3) Option Adjustable Rate Mortgages (Option ARMs); and (4) and Subprime. When a large chunk of subprime mortgages imploded in 2007 and 2008, the shockwaves took down the financial sector and the greater economy.

Several analysts estimate that the a final wave of defaults will hit the Alt-A and Option ARM categories when interest rates begin to rise, which was expected to occur right about now. Because of the Federal Reserve interest rate policy, this second wave has either been postponed or mitigated through providing borrowers with the opportunity to refinance. The exact success of such endeavors will not be known for a few more years.

Most hybrid mREITs hold large and growing positions in agency RMBSs that were acquired in order to reduce income-stream and portfolio value volatility. Additionally, since few non-agency mortgages have been issued recently, the lack of non-agency paper has forced many hybrid mREITs to accumulate larger positions of agency paper out of necessity. Several were once wholly non-agency mREITS. Adding agency paper also often includes adding leverage, given that agency paper yields significantly less.

Below are the recent performance rates and current annual dividend rates for five mortgage REITs that are largely invested in non-agency RMBS paper: 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 equity prices, these mREITs have averaged 16.07 percent equity appreciation. This compares to the S&P 500 appreciating 8.86% since the start of 2012.

See a 2012-to-date performance comparison chart for these hybrid mREITs:

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Last week, MFA, RWT and TWO reported their Q1 2012 earnings, noting robust book value appreciation of their non-agency RMBS holdings, which should bode well for the others yet to report.

Invesco Mortgage Capital is scheduled to report on Tuesday, May 8. The chart, above, clearly shows outperformance by IVR thus far into 2012, though it was also one of the worst performing hybrid mREITs during 2011, along with CIM. Chimera has been plagued with accounting issues through the last two quarters, but has still appreciated nearly 14% since the start of the year. Chimera is yet to release its 2011 year end reporting, and so a great deal of uncertainty surrounds the mortgage REIT.

These hybrid REITs have an average yield of 13.78%. Under 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 on 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.

Disclosure: I am long CIM.