Yield Spread Compression Is Trouble For Annaly And Other mREITS

Includes: AGNC, NLY
by: Doug Meeks

This was posted on the front page of Seeking Alpha on Wednesday this week.

Wednesday, July 11, 1:04 PM The Treasury sells $21B in reopened 10-year notes at 1.459% - yet another auction record low, and by a ways. Bid-to-cover ratio of 3.61, vs. a recent average of 3.17; indirect bidders take 40.6%, vs. a recent 39.4%. Direct bidders take 45.4%, vs. a recent 17.2%.

In the case of many of the mREITs the ten year treasury note is the main driver for the leverage needed to profit from the yield spread. Increasing coverage ratios coming from these unknown "direct buyers" or even from the Fed through Operation Twist, are diving the yields lower. It will be a more difficult environment to generate profits for Annaly (NLY), American Capital (AGNC) and many others.

Also, as the 10 year Treasury note rates fall it could further stimulate refinancing, bringing about an increase in the early payoff pain for the mREITs. Taking this argument one step further, it is natural to assume that the Fed, the Administration, all of California and the whole economy would love to see the retail side of the mortgage market spring back to life.

Adding more fuel to the interest rate issue is the maturation of 20% of Japan's public debt this year. Japan has the highest debt ratio of all advanced economies at over 200% of GDP. The Japanese currency is at a multi-year inflection point having moved up against the dollar for years. This is an inverse chart, so dropping slope is a strengthening Yen. Chart from Yahoo.com.

If the Bank of Japan begins to purchase this maturing debt the currency markets should forecast the beginning of a weaker yen. This chart is showing a possible trend break in Feb/March of this year. Buying US treasuries would be a good way to invest yen right now if a shift to a weakening Yen were to appear. I know I took along time with that point but with that many new yen entering the market it could be another strong reason that US Treasury rates could get pushed lower.

The US government also has a bulk of cheaply financed short term debt set to mature in the next few years. This article from Seeking Alpha covers the US debt trend moving to longer maturities. The US government has every reason to want long term rates to drop to control the cost of this huge refinance.

I see too many reasons in the macro economic picture that are pointing to a further flattening of the yield curve. Companies profiting from the spreads will do poorly if any of these scenarios take hold. Investors beware. I would suggest caution for new positions in any company counting on the yield spread to drive profits and a tightening of stops to protect existing profits.

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