In an economic environment consisting of historically low rates, investors looking for income have had to expand their universe of possible investments to include non-traditional asset classes. One of these asset classes has been Real Estate Investment Trusts (REITs) and in particular, mortgage REITs (mREITs). Mortgage REITs have historically paid very high dividends and in this article, we will evaluate the yields they have paid, how they have generated those yields, the risks they are exposed to, and finally, our comparison of 8 of the most popular mREITs. In part 1, we will look at 4 of the 8 mortgage REITs: American Capital Agency Corp (AGNC), ARMOUR Residential (ARR), Hatteras Financial (HTS), and Annaly Capital Management (NLY). In part 2, we will perform the same analysis for the additional 4 REITs: American Capital Mortgage Corp (MTGE), CYS Investments (CYS), Anworth Mortgage Asset Corp. (ANH), and Capstead Mortgage Corp (CMO). And finally, in Part 3, we will go into greater detail on our favorite REITs.
Yield vs. Net Interest Income
Mortgage REITs (mREITs) have increased in popularity over the last several years as investors sought yield in a low interest environment. The attraction is obvious as some mREITs have sported yields in excess of 15%. These attractive dividends paid out by mREITs can be attributed to two factors: Net Interest Income and Leverage. Net interest income is the difference between the amount an mREIT receives on the assets they hold and the cost of funding the purchase of those assets. Leverage is the measure of how much debt an mREIT has taken on in order to finance the purchase of those assets, and it could be a benefit or a hindrance to an mREIT. Used effectively, leverage can allow mREITs to generate very attractive returns, by allowing the mREIT to use assets as collateral for additional loans, investing in MBSs, and subsequently using those newly purchased assets as collateral for additional loans. When a REIT is said to have 7x leverage, it usually means that it has repeated the above process seven times.
But leverage can also be detrimental to the success of an mREIT, particularly when prices of the MBSs fluctuate to the extent that a margin call is triggered, forcing the mREIT to either raise additional capital or sell some assets - typically at unfavorable prices - in order to meet the margin call.
Some mREITs have historically managed leverage better than others but they all have to have some sort of leverage in order to really make investing in them attractive. The average net interest income may be as low as 1.5%. Take out operating expenses and there won't be much left to pay out as dividends. But leverage that 1.5% several times and mREITs can potentially have dividend yields exceeding 15%. The challenge then for an investor is assessing the risk that comes with that 15% yield. After all, there is no such thing as a free lunch.
In the table below, we can see that the mREITs with the highest amount of leverage have the highest projected yield. American Capital Agency Corp and ARMOUR Residential both have yields above 14%, and both of them are leveraged more than 8 times. They also have the highest net interest spread of the four mREITs listed. ARR has benefited from very low funding costs, and a relatively high asset yield, but their operating expenses are the highest of the group.
So you see that there are several different levers that mREITs can use to generate income: asset yield, funding cost, leverage, and operating expenses. A close look at the table above shows that each of these mREITs has chosen a different combination of those drivers to generate returns for shareholders.
In an environment where interest rates continue to fall, prepayment risk can be extremely detrimental to an mREIT. As interest rates fall, more and more borrowers will refinance to take advantage of lower rates, and the mREIT will be forced to write down the assets on their portfolio by the amount of any premium it paid (And most assets are bought at a premium), in addition to having to reinvest those funds at lower rates. While some of the risk may be mitigated by lower borrowing costs, this dynamic usually results in much narrower spreads going forward.
Analyzing the mREITs to determine which ones are most vulnerable to prepayments can be quite tricky. For example, in falling interest rate environment, adjustable rate mortgage (ARM) borrowers are less likely to refinance, because their rate will be reset lower and lower as rates decline. However, once interest rates begin to flatten out and the probability of interest rate increases become more likely, borrowers with adjustable rate mortgages will refinance to lock in a fixed rate for a longer period of time.
So while rates are declining, mREITs with ARMs may experience a lower level of prepayments than mREITs with more fixed rate MBSs. The challenge is determining when those rates are poised to increase, which will leave the mREIT with an ARM portfolio more susceptible to prepayments than mREITs with fixed rates. (Assuming of course that the fixed rate MBSs are already at relatively low levels on a historical basis) By looking at the table below, we see that Hatteras Financial has the highest level of ARMs in its portfolio. Not surprisingly, the Constant Prepayment Rate (CPR) on its assets are the highest among the group at 19.7%. If this trend continues, HTS will be forced to write down its assets and reinvest at lower rates. It remains to be seen if this will dramatically affect its net interest income because its asset yield is already the lowest among the group at 2.43%. But if they have to reinvest at even lower rates, the net interest spread could suffer and the dividend could decrease dramatically unless they add more leverage.
What may initially seem surprising is that Annaly Capital also has a very high CPR with 19% as of June 30th. But this has more to do with the relatively higher average asset yield of the MBSs it holds in its portfolio. As rates decline and the currently available rates become more attractive, the benefit of refinancing a higher coupon loan becomes more attractive. As the table above shows, NLY has the highest asset yield of the group, so it makes sense that its prepayment rate is higher. Annaly however, has employed the least amount of leverage of the group listed. At 6 times equity, well below its long term average and most if its peers, Annaly has plenty of room to manage its prepayment risk. I don't feel as comfortable about Hatteras.
Interest Rate Changes
One of the most talked about risks related to any fixed income security is the possibility of unexpected or rapid rises in interest rates. As interest rates rise, the value of the MBSs held in the portfolios of mREITs will tend to decline, the same behavior applicable to a traditional fixed income security such as a corporate bond. In addition, the net interest spread expected by the mREIT may also be affected by an unexpected change in interest rates. For example, as interest rates rise, the cost of borrowing, because of its shorter term, will tend to increase faster than the asset yields available in the MBSs. So the net interest spread could suffer in the short-term if these risks aren't properly managed.
Fortunately, most mREITs have hedged some of their interest rate exposure through the use of derivatives, swaps, swaptions, etc., and of course some mREITs hedge better than others. Although only estimates, the table below shows the impact of interest rate changes on both the portfolio value of each of the mREITs listed as well as the impact on net interest income.
Looking at the impact on portfolio value, we notice that NLY seems to have the least amount of volatility to the portfolio for an increase or decrease in interest rates of 50bps. This makes sense to us for two reasons: On the one hand, NLY's management is known to be one of the best in the business. It is not surprising therefore, that they are managing interest rate changes well. On the other hand, the asset yield on its portfolio is the highest of the group, so an increase of 50bps in interest rates shouldn't affect its portfolio much.
Perhaps just as important if not more important to the returns of an mREIT is the impact of interest rate changes on the net interest spread. The table below indicates that ARMOUR is very well positioned for a rise in interest rates of 50bps. An interest rate increase of 50bps would actually improve its net interest income by 6.23%. While AGNC will actually suffer a 5.4% decline to its net interest income. In fact, AGNC may experience a reduction in net interest income regardless of which direction interest rates move, although we don't expect them to decline much further, if at all.
How Risks Affect Other Components of MBSs
We have written in previous articles about the make up of American Capital Agency's portfolio. (click here), and how 70% of the assets it holds in its portfolio are considered low coupon securities. Since these securities already have relatively low coupons (interest rates), the probability of borrower refinancing is reduced and prepayment risk is minimized. We can confirm this by looking at the constant prepayment rate of AGNC in Table 2, which at 8%, is the lowest in the group. And while Hatteras also seems to have a low coupon portfolio, 93% of its assets are held in adjustable rate MBSs, which are more prone to refinancing as borrowers look to lock in fixed rates for long periods of time.
High LTV Loans
The other type of MBS that is less vulnerable to refinancing and prepayment risk are those with high loan to values. For a variety of reasons, the LTV on certain loans may be too high to allow for adequate refinancing. For example, the mortgage balance may be higher than the value of the home; or perhaps the loan may be the result of a recent purchase, which would make the additional cost of refinancing uneconomical from a timing perspective. In any case, AGNC also has a large proportion of high LTV loans, which again, is confirmed by the lower CPR it has experienced in its mortgage assets.
Finally, we also analyzed how well each of these mREITs run their operations. After all, attractive net interest spread, proper hedging, and strategic portfolio management may all be for naught if the mREIT has such high expenses it can't pay out an attractive dividend. We looked at both operating expenses relative to assets and operating expenses relative to equity. In both cases, Hatteras stands out as the most efficient. With OPEX/Assets of just 0.11% and OPEX/Equity of 1.01%, they are clearly the lowest cost producer in the group. Will this be enough to compensation for an extremely high prepayment rate and reinvestment challenges? We don't think so.
On the other hand, ARMOUR has the highest operating expenses of the entire group, with OPEX/Assets of 0.69% and OPEX/Equity of 6.86%. Despite the low prepayment rate on its assets and the attractive net interest spread, the higher operating expenses can be a concern, particularly with its 8.9 times leverage.
While there are aspects of each of these mREITs that we would strategically like to have in our portfolio, there is a clear winner in our view. That is not to say we wouldn't hold a position in all of them. We wrote about how to use REITs in your portfolio in a previous article. (click here to read more). But if push came to shove and we had to choose just one, it would be American Capital Agency Corp.
AGNC pays out a very attractive yield and in our opinion, is generating that yield with a reasonable amount of risk. The net interest spread on its portfolio is 1.65% and they generate it with low coupon assets and relatively low funding costs. They do not seem to rely too heavily on higher yields or lower funding costs, but rather, have found a conservative combination of the two.
While leverage is somewhat elevated, we do feel it has done a great job of hedging the impact of interest rate changes to the value of its portfolio. This should reduce the probability and magnitude of any margin calls. Our biggest concern with AGNC is the reduction in net interest income that may result from a change in interest rates. At a current projected yield of 14.45%, even a 10% reduction in net interest income would enable it to pay out approximately 13% yield. We have said in previous articles that all of the mREITs may be reducing dividends and we feel most confident with AGNC's ability to maintain its dividend at attractive levels.
Despite the elevated operating expenses mentioned earlier, our next favorite mREIT from the group is ARMOUR Residential . With a high net interest spread and low prepayment rate, we feel comfortable that it will continue to pay a high dividend. In addition, the impact of an increase in interest rates may actually help its net interest income, which would be a nice complement for investors who also hold AGNC. An added benefit: ARR pays its dividend monthly!!
The Riskier Alternatives
As we mentioned before, we would be inclined to hold all of these mREITs in our portfolio in some proportion, but Annaly and Hatteras would both be allocated a smaller position size. The biggest reason for our skepticism is the high level of prepayments that both of these mREITs are experiencing. Annaly management is known to be one of the best in the industry and Hatteras has a very low cost structure. However, with interest rates expected to remain low for quite some time, we feel that the higher prepayment rates will make reinvesting at attractive yields very challenging for these REITs and subsequently cause their dividend yields to suffer more than the others. In the short-term, I would pare back my positions in NLY and HTS and overweight both AGNC and ARR.
For convenience, we have added the full table of metrics below.