The mortgage REIT stocks currently are popular investment options, primarily due to dividend yields well above 10%. These companies generate income by owning a portfolio of mortgage-backed securities - MBS - and leveraging that portfolio by borrowing at short-term rates to finance the purchase of MBS bonds. Most of the mortgage REITs own agency backed securities for safety of principal and generate most of the income through leveraging the yield on the portfolios. The largest agency mortgage REITs are Annaly Capital Management (NYSE:NLY), American Capital Agency (NASDAQ:AGNC), MFA Financial (NYSE:MFA), Hatteras Financial (HTS and Invesco Mortgage Capital (NYSE:IVR).
The current interest rate environment is somewhat strange when viewed historically but fairly advantageous for the leveraged strategy used by the mortgage REITs. Short term rates are basically stuck at zero due to the current Fed policies and the Fed has indicated it does not expect to start increasing short rates until late 2014. The mortgage REITs pay more than zero percent as they borrow using repo agreements and interest rate swaps to attempt to match the expected maturities of the MBS holdings.
Mortgage rates are at all time lows and MBS rates even lower due to market demand for any kind of government guaranteed interest. However, the mREIT portfolios have been insulated from massive refinancings to lower rates by underwater homeowners and tougher underwriting standards. The mortgage REIT companies are reporting annual repayment rates on their portfolios in the range of 10% to 20%, depending on the management style. So as mortgage rates and MBS yields decline, the yields from the REIT portfolios decline at a slower pace.
However, the steady decline in mortgage rates will eventually eat into the spread the mortgage REITs can earn above their borrowing costs. Remember that costs are pretty much sitting on a zero interest rate floor. If a company reports a constant prepayment rate - CPR - of 20% it means 20% or one-fifth of the portfolio's outstanding principal amount will be repaid over the course of a year. If interest rates have declined that returned principal will be reinvested at a lower earnings rate.
Here are some mortgage related numbers for the last 16 months:
For the first four months of 2012, the average rate for 30-year fixed mortgages reported by Freddie Mac was 3.92%. For the first four months of 2011, mortgage rates averaged 4.85%.
The yield on the Vanguard GNMA Fund has declined from about 3.3% a year ago to a current 2.8%. Note these numbers look very similar to the REIT portfolio earnings rates.
The Vanguard Mortgage-Backed Securities ETF (NASDAQ:VMBS) paid an average dividend of 7.3 cents monthly for the first four months of 2012, compared to an average 8.9 cents over the first third of 2011.
From these numbers you can see mortgage rate have declined by just less than one full percent and the yields on mortgage-backed securities are down about one-half of one percent.
The mortgage REITs have also seen their yield spreads shrink over the last year. Using the first quarter results from Hatteras Financial - they all look similar - the portfolio spread declined to 1.58% in the first quarter, down from 2.15% a year earlier. An important point to note is the mortgage REITs generally reported better spreads for the 2012 first quarter than in the final quarter of 2011. The first quarter spread for Hatteras was 2 basis points better than in Q4 of 2011.
If interest rates remain at current levels, it seems that the mortgage REITs stand to lose about another one-half of one percent in yield spread. Multiply the 0.5% times your favorite amount of leverage - say 6 times - and the portfolio earnings and resulting dividend yields of the REIT stocks should slowly decline by about 3%. Investors currently earning 13% to 17% dividends will say they can live with the dividends dropping by a couple of points. The question is what happens to share prices if the dividend declines? Also, is it a better investment to hold a high yield stock with a steadily declining dividend or a moderate yield - 4% to 6% - stock which should steadily increase the dividend due to rising revenue and profits?
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.