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The launch of QE3 has taken its affect already. Where it is providing considerable momentum to the US housing markets, which had already bottomed, it is negatively affecting the mortgage REITs sector at least by accelerating their prepayment rates. The two mortgage REITs we prefer are PennyMac Mortgage Investment Trust (NYSE:PMT) and Capstead Mortgage Corp. (NYSE:CMO). Capstead Mortgage invests exclusively in adjustable rate securities, while PennyMac Mortgage invests in distressed securities which are purchased at a discount to their par values. Therefore, both REITs face the least prepayment risk.

QE3 and its Impact on Prepayment Rates

Bloomberg reported on October 3, 2012 that mortgage prepayment rates have reached their highest levels since the year 2005. The $40 billion mortgage backed security buying program has resulted in further decreasing the mortgage rates in the US which led to this acceleration in the prepayment rates for the month of August. The 30-year mortgage rate has plunged to 3.4% last week from 5.05% (last year's high). As a result refinancing applications were pushed 20% higher since April 2009.

Mortgage REITs that have purchased securities at a premium will be most adversely affected in terms of increase in their amortization costs. Mortgage REITs that have acquired their asset portfolio at a discount to the par value are the ones that will benefit from the accelerated prepayments. Besides the mREITs that invest in mortgage backed securities at a discount to their par values, mREITs that invest in adjustable rate or hybrid securities will be the ones that will get hit the least. Adjustable rate securities adjust their coupons to the prevailing interest rates, thus no need for prepayments. In the remaining of the thesis we explore such mortgage REITs that will either benefit from or will be least adversely affected by accelerated prepayments. Capstead Mortgage Corp. and PennyMac Mortgage Investment Trust we believe are the two such mortgage REITs.

PennyMac Mortgage Investment Trust

PennyMac Mortgage Investment Trust is one of the less-followed and small cap mortgage REITs that invests in distressed securities which are purchased at a discount to their par values. The REIT has demonstrated robust growth over the past and is currently attractively valued. The company's Investing Activities business segment aims to construct a portfolio of distressed securities by investing in mortgage backed securities, mortgage loans, mortgage servicing rights and real estate acquired in settlement of loans. The company will specifically benefit from the accelerated prepayments as more of those cash flows can now be reinvested at relatively higher coupon securities. The stock currently offers a 9.25% dividend yield and has a cash dividend coverage ratio of 1.44 times. This clearly reflects that the company generates sufficient cash from its operations to cover its dividend payments. For a detailed analysis on the stock, click here.

An added risk that needs to be considered before inviting in PennyMac is its credit risk. Since most of the securities are distressed and some are non-performing, the risk default risk is higher than the competitors.

Capstead Mortgage Corp.

Capstead Mortgage is a mid cap US mortgage REIT that invests its assets portfolio almost exclusively in adjustable rate mortgage backed securities. Adjustable rate securities have a tendency to adjust the coupon rate to the prevailing interest rates at the next reset date. Therefore, in the event of decreasing interest rates, the company does not face significant acceleration in its prepayments. Over the past eight quarters, the company has on average beaten analysts' estimates by over 1% as far as the bottom line is concerned.

The stock offers an elevated dividend yield of around 11%, which is well backed by an 18% (TTM) cash flow yield. During the second quarter of the current year, the company paid $45 million in quarterly dividends and generated $53.5 million cash from its operations, suggesting that the company has enough financial muscle to continue the dividend distribution.

Valuations

PennyMac Mortgage currently trades at a premium of 23% to its book value, as compared to only a 1% premium for Capstead Mortgage.

Source: 2 Mortgage REITs To Buy That Are Unaffected By High Prepayment Risk