The mortgage REIT (mREIT) is gaining the attention of more and more income investors, because its payouts far outstrip those of other income plays. The typical mREIT's double-digit yield, compared to the gilt-edge's single-digit yields or government's zero-to-negative yields, elicits two reactions: first, that it's a no-brainer; second, that "too good to be true" usually is. Well, the mREIT is not too good to be true, but neither is it a no-brainer. Here are some common fallacies I've encountered regarding mREITs.
- Yield is a function of risk. Double-digit yield says "junk."
This was one of the first alarms that went off when I surveyed the mREIT space. And normally high yield is a reliable alarm. With the mREIT, however, high yield is integral to its business model. Read down for further details.
- mREITs are about rates.
Not true. mREITs don't make money on rates but on the difference between short-term and long-term rates. mREITs have been compared to classic banks* in the sense that both are arbitrageurs.
Perhaps the most important metric for mREITs is the yield curve, which plots the yield of a given instrument over different terms, typically 3-month, 2-year, 5-year and 30-year. The steeper the curve, the wider the spread.
- Rising rates are bad for mREITs.
This is one of the most common fallacies about mREITs. While it's true that spiking rates are bad for mREITs -- and are provided for by hedges -- the ideal scenario for the mREIT space is gradually rising rates. American Capital Agency Corp. (AGNC) CIO Gary Kain explains:
[W]here there was no QE3, where we...growth-modeled along, the economy was recovering enough to keep the Fed on hold.
We probably saw interest rates in that environment going at maybe around 2.5% on the tenure, but the yield curve steepens. This would have been a Goldilock scenario for the REIT space. Why? The steeper the yield curve the better for spreads; prepayments are slower because interest rates are higher. That's all good. Returns on new purchases are going to be attractive in that environment, and generally speaking, I think the entire space does very well, and exactly what type of mortgage you have [is] not really going to be that important.
- Leverage is risky.
In itself, leverage is not risk. Leverage is money management, the decision of how much money to place at risk. For example, an agency mREIT like AGNC, that only buys government agency-backed paper, can leverage incrementally higher because its paper is more secure. In any case, the key is management. Again Kain, about leverage:
[W]hile we closed the quarter at 8.4 times leverage, which was on the higher end of where we've operated over the last two or three years, we said we have brought that down, because valuations and mortgages...in April had been very strong, and we felt that the risk return was much more two-sided. So we've brought that down some.
But one thing that we stressed was...we were very reluctant to be at low leverage, going into...a scenario where there was a reasonable probability of a QE3. Why? Because when you're underweight or when you have low leverage, that means that you're kind of saying, I'm going to buy later.
Yes, you could potentially maintain that for a long period of time, but you're still -- especially if you have faster securities -- going to be doing a lot of reinvesting. And you're going to be competing with a multiple hundred-billion dollar program from the Fed. The...last thing we want to do is wait till the Fed starts buying, to then...increase our purchases of mortgages.
We'd rather, if anything, reduce our purchases going forward if the Fed drives mortgage prices to...extreme levels. So for that reason, we weren't comfortable in running with...low leverage in that kind of environment.
It seems this very scenario has come about, with the extension of TWIST and the prospect of the Fed's buying up lots of paper. Already being leveraged up obviates the need to compete with the Fed for paper to maintain margins. Here, being low-leveraged is not a good thing.
And here leverage comes in to explain how high yields are part of the mREIT business model and not the market's rating of risk. Given a 2% spread between low and high yielding paper, the payout would be 90% (of income which REITs are required to distribute) of 2%. However, mREITs use leverage to multiply the effective spread. So that if the spread is 2% leveraged 8 times, then the payout will be 90% of 16%. This is the basis for double-digit mREIT payouts. (mREITs, unlike REITs, have negligible overhead.)
Investors of mREITs should look beyond the often oversimplified risks of yields, rates and leverage. They should look not just at mREIT yield, but yield compared to book value; not just at rates, but the yield curve; not just how much leverage, but how and when the leverage is utilized.
Prepayment risk is well-understood. Closely monitor the Conditional Prepayment Rate (CPR) and observe how an mREIT responds by portfolio selection and hedging. For example, in anticipation of prepayments, an mREIT might overweight low-balance portfolios. To cover the added exposure of premium mortgage prepayments, an mREIT might hedge the premium.
And finally, it is important to read earnings reports, conference calls and presentations, all reported by Seeking Alpha, where you gain direct insights into specific mREIT management philosophy and strategies.
Due to their stable behavior midst broader market chaos and the transparency of their high yields -- no black boxes -- the mREITs represent the ideal space for the income investor. Once in the space, due diligence requires scrutiny of management, for in my view management is the dynamic element -- adapting portfolios to changing market conditions -- which is crucial to the performance of the mortgage REIT.
Among the highest yielding mREITs is also the best managed, the aforementioned American Capital Agency Corp. AGNC is exposed to the same risks as its agency mREIT peers, yet its results surpass them by adroit adjustment of portfolio mix, leverage and hedges. AGNC and its younger sibling American Capital Mortgage (MTGE) have common management: Gary Kain is CIO of both. Unlike AGNC, MTGE is chartered as a hybrid mREIT. In practice, however, MTGE's holdings of non-agency paper amount to less that 3%. Because MTGE's market capitalization is still building through secondaries, there may be more room for book value growth than AGNC. One might picture MTGE as AGNC at an earlier stage of development, in effect a second chance for those who regret not getting into AGNC sooner.
In the mREIT space, I strongly recommend AGNC and MTGE. MTGE declared a secondary issue before it went ex-dividend, and AGNC has yet to announce a secondary, although it customarily does, post-ex. Those wishing to enter the mREIT space should look at the history of secondary issues to see how regular they are. Because of the mREITs' low beta, secondaries afford good entry-point opportunities. Another way to choose an entry point is to sell a covered put for the desired mREIT at a striking price which represents the desired entry point.
Remember, mREIT management are aware of the same risks we are. We must understand these risks the same way they do, in order to make sense of their strategies.
*Classic banks refers to Glass-Steagall era banks. It's dismaying to hear Morgan-Chase's (JPM) Jamie Dimon and the politicians affirm as a given, that "banks are in the risk business." There's a venerable but apparently obsolete banker's maxim: "Risk is for insurance companies." The classic bank's business model includes a circumscribed financial space -- rate arbitrage -- in return for government's underwriting of residual risk. Without Glass-Steagall the bank space is no longer circumscribed and yet still relies on government underwriting. If the reckless assertion that banks are in the risk business continues to go unchallenged, then we are embarking on yet another ruinous era.