While many equity investors have been fretting recent downtrends across the global stock markets, investors in agency mortgage REITs have been comforted by their recent strength. 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 RMBS, the paper comes with an agency backing and an implied U.S. government backing.
The recent strength in agency mREITs is founded on the fact that the business is based on holding agency debt, and usually leveraged quantities. Agency debt valuations can be similar to treasury valuations, but there is a key characteristic difference in that agency debt is often prepaid, which is like a bond being called. When this happens to a mREIT, it must find a new investment. The remainder of a mREIT's portfolio would likely increase in value.
As borrowers defaulted during the sub prime crisis of 2007 and 2008, and continued to default over time, government agencies must either make payments on behalf of the defaulting borrower or buy out their defaulting obligations. Thus far, the federal government fully funds the operation, making the credit difference between agency and treasury paper a matter of semantics.
The difference could become significant if the federal government would ever choose to terminate the current policy. Currently, though, the vast majority of mortgages being issued within the United States are through federal agencies. This does make the market large and liquid, and within it these agencies have been able to call in much of their old, high-yielding paper and substitute it with lower-yielding paper.
Below, I have provided recent performance rates for five reasonably liquid and high-yielding Agency Mortgage REITs: American Capital Agency Corp. (AGNC), Annaly Capital Management, Inc. (NLY), Capstead Mortgage Corp (CMO), Cypress Sharpridge Investments (CYS) and Hatteras Financial Corp (HTS). I have provided one-week, one-month, three-month and 2012-to-date equity performance rates, as well as each REIT's yield.
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So far this year, these mREITs average 7.18 percent appreciation, while also providing an average yield of 13.64 percent. This compares with a flat year-to-date performance by the S&P 500 (SPY), which now yields about 2.06 percent. This is a fairly high yield for the S&P 500, especially compared with current treasury rates, but these mREITs have already paid out more from their Q1 dividends than the average annual yield of the benchmark.
As explained above, when an agency buys defaulting mortgages, the holder of the paper is cashed out. This prepayment requires these mREITs 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.
Still, as it works out, the capital appreciation one would have received by holding a long-term treasury would have significantly surpassed the performance of these mREITs. Over the last month, a 20-year treasury would have appreciated by about 10 percent.
These mREITs have likely recognized book value appreciation so far into the second quarter that is yet unreported. Book value is a key factor in this. Prepayments will likely be higher than during Q1, which could start to be an issue. New paper will be very low yielding, and old paper will be trading at historic premiums.
Spreads are also getting tighter. See the spread between 10-year and 2 year treasury bonds, which moves in a manner that should be somewhat analogous to the pre-leverage profit margin of an mREIT.
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A big concern to these mREITs and all government-related debt holders is that interest rates will eventually rise and that this will devalue existing fixed income instruments. Since the mREIT 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.
Most agency mREITs will announce their Q2 dividends at some point in the second half of June. It appears that many should be able to maintain their dividends, or possibly even increase them. I would imagine, though, that it may be preferable for some of these mortgage REITs to hold onto some extra cash for deployment during a potential treasury correction. Of course, waiting for such a correction would have hurt an mREIT's performance over the last several quarters.
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.
Disclosure: I am long NLY.
