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In an earlier article, I wrote about the iShares FTSE NAREIT Mortgage Fund ETF (NYSEARCA:REM) as a good way to generate income in an environment where interest rates are low, and yields on investment grade bonds are quite possibly at long-time lows. In that article, I mentioned the two largest holdings within the REM but went on to describe the benefits of investing in the ETF. Subsequent to that article being published, I received a few comments and specific feedback disagreeing with REM as an attractive investment, but that investing directly in the two underlying companies mentioned was better. After further analysis, I agreed with those comments.

The two mortgage REITs that make up the two largest positions in REM are American Capital Agency Corp (NASDAQ:AGNC) and Annaly Capital Management Inc (NYSE:NLY). They both focus on investments in mortgage pass-through securities and collateralized mortgage obligations (CMOs). They make money by borrowing at a low interest rate and investing in mortgage securities that pay a higher interest rate, profiting from the spread. While I initially thought that an ETF would be a more attractive investment because of the diversification, I found that the performance of REM significantly lagged the performance of both AGNC and NLY over all periods analyzed. So, based on that discovery, I further researched each of the mortgage REITs in more detail and will summarize them here.

AGNC vs. NLY

As I have already mentioned in previous articles, the attraction of these investments in the current low-interest rate environment is their high-dividend yields, which are 14.7% and 13% for AGNC and NLY, respectively. In addition, because the mortgages they invest in are guaranteed by government agencies, including Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC) and Ginnie Mae, credit risk is all but eliminated. But while their business models may look quite similar, there are some differences to note that will impact the volatility of the stock of each, as well as future profitability in an inevitable increase in interest rates.

Leverage

Most, if not all, mortgage REITs operate with a high level of leverage. AGNC has a debt/equity ratio of over 9x and there are others with even higher levels. NLY, however, seems to have a more modest leverage of 6.5x. Still high on an absolute basis, but conservative compared with industry peers. Since mortgage REITs must borrow at very short terms, NLY is better positioned to handle any decline in access to funding as well as having less likelihood of having to fund a margin call. With slightly less leverage, NLY has a bit more cushion to withstand any declines in the value of its holdings.

Portfolio

NLY holds a majority of assets in adjustable or floating rate mortgages. The portfolio consists of 2/3rds adjustable rate mortgages and 1/3 fixed rate mortgages. AGNC has $78 billion of their $80 billion in mortgages in fixed rate securities. The implications of this are that as interests rates eventually rise, the value of the fixed rate securities is more sensitive to these interest rate changes and the value of the holdings in AGNC's portfolio will decline more than the securities within NLY's portfolio. If the decline in asset prices is substantial, margin calls may be triggered, causing AGNC to sell assets at the depressed levels in order to meet those margin calls. The positive factor of the fixed rate securities is that they are probably at higher interest rates, which could be a factor contributing to the higher yield that AGNC pays. Although both REITs use hedging strategies to minimize the impact of interest rate risk, on the surface, it would seem that NLY is better insulated against such risks.

Other Risks

Mortgage REITs are also exposed to other risks inherent in the type of business they operate in. For example, prepayment risk is the possibility of borrowers prepaying their mortgages as interest rates decline to refinance at a lower rate. Since we don't think rates can get much lower, we think this risk is minimal. But prepayments may also be driven by real estate sales. For example, when a home is sold, the mortgage on that home is typically paid off. This is a form of prepayment risk, which, while relatively low right now, may increase if the housing market ever turns around.

And finally, there is funding risk. Since mortgage REITs rely on short-term funding, (typically 30-90 days), there's a risk that financing may not be available or may only be available at less favorable terms, causing the net interest earned to decrease. So far, this has not been an issue for either of these REITs, but the capital markets are very skittish right now and a continued crisis in Europe could eventually affect markets worldwide.

AGNC or NLY

We really like Mortgage REITs as a way to enhance income within a portfolio. And while we recognize the risks of these types of investments, we think the risk return profile of these investments would be complementary to a traditional equity/fixed income portfolio. If you are an investor satisfied with a 13% yield, then NLY may very well be the best option for you. It seems it has slightly less risk to some of the factors that could affect future performance, and its portfolio is more conservatively positioned. But if you want the additional 2% yield that AGNC pays, I would suggest a close eye on interest rates and housing sales, as these two factors may impact AGNC more negatively with the current portfolio of mortgages it holds. Or you can invest in both. In any case, we will continue to monitor these investments and follow up with another article as new information becomes available to us or the economic environment changes.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Considering REM? Invest Directly In Mortgage REITs For Higher Yields