Continuing with our comparison of mortgage REITs, we find ourselves writing this at an interesting time. Many mREITs have dropped considerably over the last 30 days due to the Fed announcement of QE3 and the expectation that prepayments will continue to trend higher and reinvestment rates will be lower. The result of which is spread tightening on the net interest that mREITs earn by borrowing capital with short maturity and investing it in mortgage-backed securities (MBS).
In Part 3 of our series, we cover Chimera Investment Corporation (CIM), Two Harbors Investment Corp. (TWO), Invesco Mortgage Capital (IVR), and MFA Financial, Inc. (MFA). Coincidentally, all four of the these REITs are considered hybrid REITs because they invest in both Agency and Non-Agency MBSs. We didn't do this intentionally, so we won't take credit for that. It just worked out that way.
For those with less knowledge of the mortgage REIT industry than others, an Agency MBS is one backed by one of the three government sponsored agencies, also known as FNMA (Fannie Mae), FHLMC (Freddie Mac), and GNMA (Ginnie Mae). Implicit in these MBSs is that they are backed by the US Government and therefore are risk-free. And while the creditworthiness of the US government has increasingly come under scrutiny lately, for our purposes, we will assume that the US will pay its debts.
Non-Agency MBSs on the other hand, are not backed by one of the three agencies. They typically do not meet the criteria of the agencies in regards, to loan-to-value (LTV), credit scores, income ratios, and any number of other criteria so they do have exposure to credit risk. Because of this, and due to the characteristics of the loans, they tend to have higher yields that are accompanied by a higher risk profile.
The Search for Income
As we mentioned in Part 1, investors looking for income have had to expand their universe of possible investments to include non-traditional asset classes. And even though many investors have previously invested in REITs, there has been an increasing reliance on the dividends paid by REITs to provide investors with the income levels they desire. In fact, mortgage REITs pay some of the highest dividends of all of the REITs in the marketplace. But investors should take heed of the risks they are taking in order to generate those dividends, and which mREITs not only can continue to pay dividends, but are implementing strategies and risk management to mitigate the risks inherent in their strategies.
Yield vs. Net Interest Income
The yield an mREIT pays out is directly proportional to the net interest spread it generates on its investments and the amount of leverage it uses to 'multiply' that spread. The higher the leverage and the higher the spread, the higher the yield that investors can expect to receive. So long as everything goes as planned, leverage can be good. But when something goes wrong, (like a rapid increase in interest rates, higher-than-anticipated defaults, increases in refinancings, etc.) leverage can ruin an mREIT, and leave investors with a bad taste in their mouths. While some mREITs may manage leverage better than others, we first want to look at how much leverage an mREIT has.
What we find with these Hybrid REITs is a substantially higher yielding portfolio that varies depending on the proportion of Non-Agency MBS, as well as the percentage of fixed rate versus adjustable rate mortgages (ARM) in each respective portfolio.
In the table below, we summarize some of the key return metrics for each of the mREITs we are covering in this article. For Chimera, the data shown is through December 2011, as it is currently in the process of restating its financial statements and has been granted until January 2013 to do so) You may notice that three out of the four have reduced their dividends lately so that the projected yield is expected to be slightly lower than the yield over the previous 12 months. The one exception is Invesco and that may just be a matter of time. What also might jump out at you is Chimera's whopping 7.21% average asset yield. The reason for this is that Chimera's portfolio consisted of over 71% Non-Agency MBS - of which 83% was rated below B or not rated at all. If that is not troubling enough, the reason for its restatements have to do with how it has accounted for its Non-Agency portfolio and how it conforms, or doesn't conform to GAAP accounting standards.
As for the other three mREITs, it is interesting to note how each one uses a different combination of portfolio strategy, funding costs, and leverage, to generate their double-digit dividend yields. Two Harbors has about 20% of its portfolio in Non-Agency MBS, which generates approximately a 9.6% yield. This explains its very attractive 4.6% asset yield. MFA Financial, on the other hand, has up to 40% of its portfolio invested in Non-agency MBSs, but at a yield of only 6.75% on average. And finally, Invesco Mortgage holds only 15% in Non-agency MBSs and a combination of collateralized mortgage obligations (CMO), Commercial Mortgage Backed Securities (CMBS), and the residential mortgage backed securities (RMBS), the majority of which is in RMBS.
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 its portfolio by the amount of any premium it paid, 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. We previously mentioned that three out of four mREITs are projected to have lower dividend yields over the next 12 months, compared to the dividend yield over the previous 12 months.
Analyzing the mREITs to determine which ones are most vulnerable to prepayments can be quite tricky. It really depends on whether interest rates are rising or falling, whether the mREIT holds more fixed rate versus adjustable rate MBS, and the general trend in housing sales, etc. For example, in a 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 reach a bottom, which might be where we are now, borrowers with adjustable rate mortgages will refinance to lock in a fixed rate.
We can reasonably assume then that an mREIT with a high percentage of ARMs would experience a high level of prepayments when rates are bottoming and expected to rise. In the table below, we notice that the relationship holds true. MFA Financial, with 74% of its portfolio in ARMs, has a constant prepayment rate (CPR) of 18.2%, while Two Harbors, with only 2% of its portfolio in ARMs, has a CPR of just 5.6%.
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.
In the table below, we can see that with the exception of Chimera (and its data hasn't been updated), the other three mREITs have hedged away much of the impact on portfolio value by any changes in interest rates. TWO seems to have the highest risk of a rise in interest rates, but is still relatively muted.
The effect of interest rate changes on net interest income, however, looks quite different. In fact, in the table below, we point out that Invesco could stand to lose almost 50% of its net interest income if rates fall by 1%. But it also stands to gain almost 12% if interest rates rise. As a matter of fact, if interest rates only rise by 50bps, it would increase its net interest income by 20%. The reasons for this is because Invesco has entered into interest rate swaps whereby they pay a third party a fixed rate, and in return receive a variable rate. If interest rates rise, the payments they receive would be higher, but the payments they make would remain the same. (In theory at least.)
How Risks Affect Other Components of MBSs
So far in our Comparing Mortgage REITs series, we have not covered a REIT with a substantial portion of its portfolio in Non-Agency MBSs. In this part, all four of the mREITs have a considerable amount in Non-agency paper, which exposes them to credit risk and/or the risk of default. In our peer group, Chimera has the highest percentage in Non-agency MBSs and it also has accounting issues. Things may turn out to be okay, but visibility on the results of its restatements is limited and we find it to be too risky for our palate.
We like how Invesco has hedged its net interest income through the use of interest rate swaps. In an environment where rates are sure to rise sooner or later, it would be a good complement to an investor's portfolio whose behavior is more typical of fixed rate securities. The risks in the short term are that interest do fall further before they rise, which would have a very negative impact on its net interest income. It would also be interesting to note how its 13% CPR will affect its dividend yield going forward. Invesco also looks reasonably valued at 1.1 times book value.
The Speculative Play
As we mentioned early on, there are issues at Chimera that it is currently working through. We don't know how that will play out and how the rest of the market will react to the results of its restatement. I would caution an investor to stay away from CIM if they are looking for income. If, on the other hand, we get any positive news regarding restatements, its price may get a boost. It is currently very cheap at just 0.8 times book value. But be warned, it may be cheap for a reason.
To read more about how to use REITs in your portfolio, see our previous article on Seeking Alpha.