Mortgage REITs maintain portfolios composed primarily or exclusively of residential mortgage backed securities and analogous paper. Within the world of residential mortgage REITs, there are two primary types: those that only hold RMBSs insured by federal agencies and those that will also hold RMBSs without any such agency insurance.
Agency mREITs have portfolios composed of residential mortgage backed securities that are insured by federal agencies. Because government agencies underwrite the mortgages and issue the RMBSs, the paper comes with an agency backing and an implied U.S. government backing.
As borrowers defaulted over the years, and continue to default over time, these agencies must either make monthly payments or buy out defaulting obligations. Thus far, the federal government continues to fund the operation, making the credit difference between agency and treasury paper a matter of semantics, though the difference could become considerably more real in the future, should the federal government ever choose to terminate the presents policy.
When these agencies buy defaulting mortgages, the holder of the paper is cashed out. This is a type of prepayment and, in the case of a mREIT, will require the REIT to reinvest the cash into new paper. Prepayments will affect a mREIT's quarterly income, yield, asset valuation and margins, largely to the extent that interest rates have changed. Currently, this means that the REIT will lose higher yielding paper and replace it with lower yielding paper. Be that as it may, prepayment is substantially preferable to an outright 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. (NYSE:NLY), Capstead Mortgage Corp (NYSE:CMO), Cypress Sharpridge Investments (NYSE:CYS) and Hatteras Financial Corp (NYSE:HTS). I have provided one-week, one-month, three-month and 2012-to-date equity performance rates, as well as each REIT's yield.
So far this year, these mREITs average 8.87 percent appreciation, while also providing an average yield of 13.54 percent.
Two weeks ago, the majority of agency mREITs declined along with most high-yield securities, as investors flooded into, higher rated, lower yielding paper. This decline appeared more related to a high yield allocation shift rather than to a re-pricing of the leverage or interest rate risk that agency RMBS investing mREITs possess.
Last week, though, all of the above-mentioned mREITs appreciated, with the average weekly gain being 3.36 percent, essentially extinguishing any fire-sale losses from the prior week. See a 1-month performance comparison chart for these five mREITs, showing this recent activity:
One concern that could one day affect these agency mREITs is that interest rates will eventually rise and that this will devalue the assets held by these mREITs. Since the industry standard is to leverage assets in order to multiply the return, generally at rates between 5x and 9x, leverage and interest rate risk may be considerable.
If rates rise, then the book value of assets may have similarly multiplied losses. Most mREITs attempt to hedge such risks, but the efficacy of these strategies is as of yet untested and also mitigates the positive affect to book value when rates decline, as they have been. Nonetheless, these mREITs have likely recognized book value appreciation so far into the second quarter.
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.