Why The Mortgage REIT Is A Great Defensive Stock

 |  Includes: ADM, AGNC, BTE, MTGE, NLY, NYMT, XOM
by: Jack Rice

A defensive stock is a "just in case" stock, one that will make money in bad times. Defensive stocks should be straightforward and tied to fundamentals, so they don't add complexity to your portfolio. Commodity stocks -- agriculture, mining, energy, bond funds -- make good defensive stocks because their relationship to their underlying commodity is straightforward and, to varying degrees, reflect macroeconomic factors which are easy to track and anticipate. Archer Daniels Midland (NYSE:ADM) depends on the price of grain, Exxon Mobil (NYSE:XOM) depends on the price of oil, mortgage REITs depend on rates. High inflation? Buy an energy stock. High deflation? Buy a mortgage REIT.

I use the qualifier "to varying degrees," because the relationship between macroeconomics and stock price is subject to variables. For example, between the wellhead and the pump is the refinery, and for an integrated oil company, refinery capacity and output are a big factor in the bottom line, regardless the price of oil out of the ground. Thus, many oil producers stay out of the "downstream" business.

Macroeconomic factors are easy to track and anticipate, because in this context, rates are trailing indicators, i.e. they trail facts on the ground. If you live in a bellwether city, like Atlanta or Portland or Phoenix, then when you observe business picking up or slowing down, you can be reasonably sure that rates will follow. And as rates go, so will mREITs.

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In a deflationary recession, an mREIT like American Capital Agency Corp. (NASDAQ:AGNC) is an ideal defensive holding.

mREITs behave like commodity stocks, but for mREITs there are fewer variables between rates and the price of the mortgage commodity. When rates go up, the prices of currently-held mortgages go down and vice-versa. And while many factors can affect oil or grain prices -- war, famine, disaster, production -- only one factor affects rates: the economy. Yes, war, famine, disaster and production are felt by rates, but only through their economic impact. Even then, their impact isn't certain. For example, through the 9/11 wars and the real estate bubble, mortgage rates continued their secular decline.

Through war and real estate bubble mortgage rates have continued their secular decline.

Like traditional banks mREITs make their money on the spread between the interest they pay on the short-term money they borrow and the interest they earn on the long-term paper they buy with that borrowed money. When the spread widens they make more money, when it narrows they make less. The risks are big rate changes, which they hedge against, and prepayments, which they provide against by portfolio selection. The rewards and risks are magnified by leverage. If the spread is 2%, and the leverage is 8x, then the gross spread or margin is 16%. As REITs, they must distribute 90% of their income, so the dividend on 16% would be 14.4%.*

This scares investors, because such a yield is usually only found in junk and is even higher than what Madoff offered. But high yield through leverage is integral to the mREIT business model, not the result of poor corporate health or some kind of black box. Furthermore, as risk decreases and decreases, leverage is adjusted accordingly. For example, if the Conditional Prepayment Rate (CPR) rises, thus raising the risk of prepayment of a given portfolio of MBSs, then leverage is lowered.

Since mREITs must distribute 90% of their earnings, they grow their portfolios through secondary share issues. But since the money raised by these issues is used almost exclusively to grow assets, they are regarded as accretive rather than dilutive. Thus, investors see the down-ticks from these secondaries as entry points.

Key mREIT metrics are yield curve, which plots the changes in yield from short-term to long-term paper -- the steeper the curve the bigger the spread -- and Conditional or Current Prepayment Rate -- the percentage of prepayments in a given period, so if the CPR is 18, then 18% of mortgages are being prepaid. For mREIT stocks, book value is a more significant metric than earnings, so the P/B ratio is followed more than P/E. mREITs have extremely low P/Bs; some are even negative, i.e. their book values are higher than their prices.

So-called "agency mREITs" have the added asset security of dealing only in paper backed by the government or a government-backed agency. Some mREITs favor slowly rising rates, because prepayments are minimal, the yield curve is steeper, and "slowly" allows them to roll their portfolios without taking a big hit on book value.

As long as the economy is cool, rates aren't going to rise anytime soon, and when they inevitably do rise, they will rise gradually. The advantage of mREITs is that if this simple projection holds, then mREITs will prosper. There are no jokers to complicate the picture. For this reason, mREIT sticks are far less subject to technical factors than conventional sticks, as attested by mREITs' uniformly low betas.

The defensive investor is thinking about tidal forces, he should also be looking at defensive stocks for buy-and-hold rather than for trading. Thus, entry points are not as important as price stability and corporate health. Among mREITs with good balance sheets are AGNC, American Capital Mortgage Corp. (NASDAQ:MTGE), New York Mortgage Trust (NASDAQ:NYMT) and Annaly Capital Management (NYSE:NLY). Because of their low betas, market timing is less of a factor for buying mREITs. Historically, mREITs tend to recover faster from ex-dividend and secondary share issues.

Of course, there are defensive stocks against defensive stocks. If you feel the need to hedge your long mREIT position against a rate spike, then instead of buying a put, buy an energy stock like Baytex (NYSE:BTE); unlike an option hedge, this "stock hedge" throws off a monthly dividend of 22¢, which will please the income investor.

Summary: Mortgage REITs have a straightforward relationship to one variable, interest rates. As such they can be seen as commodity stocks. As commodity stocks mREITs make ideal defensive holdings for deflationary periods such as the current recession.


*There are adjustments such as asset yield, cost of funds and operating expenses.

Disclosure: I am long AGNC, MTGE.