We believe mortgage REITs will continue to outperform with regards to their book values. QE3 will drive the book values higher, while lowering coupons on mortgage-backed securities. Given the scenario, we believe American Capital Agency (AGNC) and AG Mortgage Investment Trust (MITT) are well positioned to benefit from the new round of quantitative easing, given their combination of lower coupon fixed rate asset portfolio. Having said that, we believe the interest rate spreads for most of the mortgage REITs will decline.
Last Thursday, the Fed announced another round of stimulus for the sluggish U.S. economy. The bank aims to purchase mortgage-backed securities worth $40 billion a month, until it feels that the support is not necessary. Besides this, the bank intends to keep short term rates at record lows until mid-2015, instead of the previous 2014 target. These efforts will result in a downward pressure on long-term interest rates, making the broad financial markets more favorable and supporting the mortgage markets. In other words, it means the yield curve that has already flattened as a result of the Fed's previous initiatives (Operations Twist and the maturity extension program), will flatten further, squeezing the interest rate spread that these mortgage REITs earn between their interest income received and cost of funds paid. A lower interest rate spread will hurt future profits. Therefore, any twist in the yield curve will play a key role in future revenues that these REITs generate. Where the flattening of the yield curve will result in a decline in the net interest income earned by these REITs, it will also lead to an increase in the book values of these REITs.
Therefore, in the shorter term, we believe mortgage REITs will suffer from lower interest income and increased valuations. However, lower long-term rates will also result in increased prepayments, which will increase the amortization expense on securities acquired above par. Lower long-term interest rates will lead to more refinancing by borrowers, resulting in prepayments, which will hurt mREITs' returns. Mortgage REITs that have positioned their asset portfolios in a way to reduce the exposure to prepayments will outperform. Exposure to prepayments can be reduced if the company invests in lower coupon mortgage-backed securities. The conditional prepayment rates (CPR) for American Capital Agency , Hatteras Financial (HTS), Anworth Mortgage Asset (ANH), Annaly Capital Management (NLY) and Capstead Mortgage (CMO) are 12%, 25.7%, 22%, 19% and 14.5%, respectively. This means that American Capital has to replace the least proportion of its portfolio with lower coupon securities.
The graph below shows a clear positive relationship between the dividend per share paid by American Capital Agency and the 2-10 year treasury yield spread. With the increase in the spread between the 2-year and 10-year treasury yields, the dividend per share also increases.
In the aftermath of the Fed announcement, analysts have downgraded most mortgage REITs. Bank of America Merrill Lynch has downgraded American Capital Agency , Annaly Capital Management , Chimera Investment Corporation (CIM), Hatteras Financial and Invesco Mortgage Capital (IVR) to neutral. With the exception of Invesco Mortgage , all of the REITs invest exclusively in Agency mortgage-backed securities. Invesco has some holdings in non-Agency securities.
On the other hand, we believe AG Mortgage Investment Trust , a small-cap mortgage REIT with a market cap of $516 million, which seeks to increase the proportion of non-Agency mortgage-backed securities, will benefit from this new round of easing. With QE3 implemented, the company will be able to sell its Agency securities and add up high yielding non-Agency securities.