The announcement of the third round of quantitative easing is a welcome sign for the economy in general. It has accelerated the slide in the mortgage REITs sector by accelerating the prepayments, as refinancing touched a three year high, and contracting the interest rate spread that these mortgage REITs earn. In such a scenario, we have identified three such mortgage REITs which we believe will be least adversely affect by the aforementioned risks. These mortgage REITs are American Capital Management (NASDAQ:AGNC), Armour Residential (NYSE:ARR) and PennyMac Mortgage Investment Trust (NYSE:PMT). We recommend investors wishing to play the mortgage REITs to long the three stocks.
Impact of QE3 on mREITs:
As a result of the announcement on September 13, 2012 by the Federal Reserve Chairman Ben Bernanke to launch another round of easing to stimulate the sluggish US economy which is showing no signs of respite, mortgage rates have come down. 30-year mortgage rates were at 3.55% when the third round was launched; they are at 3.39% today, encouraging refinancing. As the Fed accelerates bond buying, we believe the mortgage rates in the US will come down further.
The historic low interest rates have pushed homeowners to refinance their mortgages with applications for refinancing in close proximity to their three year high. New home purchase applications are also at their highest level since June of this year. According to the survey conducted by Mortgage Bankers Association, the seasonally adjusted index of refinancing applications gained 0.8%. Refinancing has a total share of 81% of the total mortgage activity, which is 100 basis points above the share a week ago. Accelerated refinancing lead to accelerated prepayments, increasing the amortization costs for mortgage REITs.
Contraction in Spreads:
Another adverse impact of the third round of quantitative easing on the mortgage REITs is the decline in the long term mortgage rates, which results in contraction of the interest rate spreads mortgage REITs earn. This suppressed interest rate spread is creating downward pressure on the elevated dividend yields for which mortgage REITs are famous. If the Fed accelerates its MBS buying, we believe the rates will decline further, creating pressure on the profits mortgage REITs make. The Fed announced on October 11, 2012 that it had acquired $150 million of mortgages, $50 million more than what it purchased a week ago. This demonstrates the Fed's intension to accelerate the MBS buying program. The prolonged low interest rate environment and the flattening of the interest rate yield curve have already resulted in suppressed interest rate spreads for JPMorgan during the third quarter of the current year. We believe, the trend would continue with mortgage REITs when they report their performance for the third quarter. Investors can expect further dividend cuts due to this increased pressure.
Accelerated refinancing and contraction in the interest rate spreads have led the entire mortgage REITs sector to slide. The Bloomberg index of REITs shares plunged 4.5%, the highest drop in the past one year. American Capital Agency and Annaly Capital Management (NYSE:NLY) are among the noticeable decliners. In the post QE3 scenario American Capital Agency, Armour Residential and PennyMac Mortgage Investment Trust are our most favored mortgage REITs.
PennyMac Mortgage Investment Trust operates as a small cap mortgage REIT which seeks to invest in distressed securities purchased at a discount to their face values. Since a majority of the investments that the REIT makes are in securities purchased at discount, we believe the company would be least adversely affected by accelerated prepayments. Despite the fact that the stock trades at 24% premium to its book value, the company offers a sufficiently attractive dividend yield of 9.14% which is well backed by a cash dividend coverage ratio of 1.44 times.
American Capital Agency is one of the most followed mortgage REITs with the lowest conditional prepayment rate (CPR) of 12%, low balance and low coupon securities holding 70% of the entire asset portfolio. This means only 12% of the securities that the company holds will be maturing. The stock offers a dividend yield of 15% which is well backed by an operating cash dividend coverage ratio of 1.7 times.
Armour Residential is another of our favored mortgage REIT with low prepayments and a high interest spread. Around 22% of the assets portfolio consists of adjustable rate securities which have less prepayment risk. These securities adjust their coupons to the prevailing interest rates, thus reducing the need for prepayments. Besides, the company has a relatively low conditional prepayment rate (CPR) of 19%. During the second quarter of the current year, the company earned one of the highest interest rate spreads of 2.15% compared to the just 1.54% for Annaly Capital Management and 1.65% for American Capital Management. Moreover, the company has already announced a 10% decrease in its monthly dividends. A further decline in the interest rate spread will most likely not lead to a decline in dividends in the coming quarters.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The article has been written by Qineqt's Financials Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.