It has just been over a month since the Fed announced the launch of the much-awaited third round of easing (QE3) to stimulate the sluggish U.S. economy, which was showing no signs of respite, despite previous efforts made by the U.S. Central Bank. Much has been said about the impact of this new round of easing on mortgage REITs. We believe QE3 will lead to decreased mortgage rates, accelerated prepayments and enhanced book values for agency mortgage REITs. We also believe that non-agency mortgage REITs will benefit the most from QE3. While we have a clear preference for non-agency mortgage REITs, particularly Newcastle Investment Corp (NCT) and PennyMac Mortgage Investment (PMT), we also favor American Capital Agency (AGNC) among the Agency mortgage REITs.
Within the third round of easing, the bank seeks to purchase $40 billion worth of mortgage-backed securities each month, until the U.S. labor and housing markets show an improvement. So far, the effects of the third round have been notable. Unemployment rate dropped below 8% to 7.8%, the lowest since the past four years. Where the launch was considered a welcome sign for the U.S. economy in general, it has the effect of decreasing longer term mortgage rates and the resultant decrease in the spread between the U.S. mortgage rates and short term treasuries, while accelerating prepayments for the mortgage REITs sector. The purchases made by the Fed have succeeded in bringing down mortgage rates. Pre-QE3, the 30-year mortgage rate was at the level of 3.55%, which fell to its all time low level to 3.36%. As a result, the high yielding mortgage REITs ETFs have stumbled. Both mortgage REITs ETFs (REM) and (MORT) have declined by over 5% since the announcement of QE3.
We look at American Capital Agency (the agency REIT) and New Castle Investment Corp and PennyMac Mortgage Investment Trust (the two non-agency REITs). We have a preference to non-agency REITs, which usually buy MBS at par or below, hence unaffected by prepayments. The graph below also shows price appreciation since the announcement of QE3 for the stocks of the two REITs with a majority of non-agency mortgage backed security holdings. Non-agency mortgage REITs have outperformed agency mortgage REITs.
Record low 30-year mortgage rates of 3.37% have resulted in acceleration refinancing and the resultant higher prepayments for the bondholders. However, we believe the initial downward pressure has now been eased as the mortgage rates start to rebound moderately. After a surge of almost 20%, mortgage refinancing applications touched their highest since April 2009, while U.S. mortgage prepayment rates hit their highest since 2005. August CPR for home loans advanced from 21% in June to 25%. This accelerated prepayment is a key to the success of the third round of easing by the Fed, since it would additional money in the pockets of the homeowners.
A closer look at the Conditional Prepayment Rates (CPR) of some of the mostly followed Agency mortgage REITs reveals the fact that American Capital Agency has the lowest CPR of 12% at the end of the second quarter of the current year, followed by Capstead Mortgage (CMO) at 14.5%, Annaly Capital Management (NLY) at 19%, Anworth Mortgage Asset (ANH) at 22% and Hatteras Financials (HTS) at 25.7%. American Capital Agency has a clear advantage as only 12% of the company's portfolio will be replaced against 25.7% portfolio replaced for Hatteras Financials.
Therefore, American Capital Agency would be least affected by this acceleration in prepayments.
Another consequence of the launch and implementation of the third round of easing (QE3) is the contraction of Agency spreads between the mortgage backed securities and the treasuries. This is the spread that these Agency mortgage REITs earn in order to pay out elevated shareholder distributions later. Mortgage bond spreads fell to record lows soon after the launch of the third round of easing. Fed's bond purchasing pattern reveals that it intends to speed up the bond purchasing in the coming future, which means further contraction in the spreads that mortgage REITs earn. In such a case investors can expect dividend cuts in most of the Agency mortgage REITs.
We believe non-Agency spreads will benefit from the third round of easing since the decline in Agency mortgage backed securities will tilt investors towards the high yielding non-agency mortgage backed securities. The general improvement in the U.S. housing sector has lowered the default rate, decreasing credit risk for non-agency mortgage backed securities. Both PennyMac and Newcastle are majorly invested in non-Agency mortgage backed securities, which is why we believe they will be the major beneficiaries.
Mortgage REITs are famous for the elevated shareholder returns. All the REITs considered in the investment thesis are no exception. American Capital Agency offers a dividend yield of 15.2%, while PennyMac and Newcastle offer 8.7% and 11.2% dividend yields. The cash dividend coverage ratio for PennyMac is 1.44 times, while the same ratio for Newcastle is 1.12 times. The cash dividend coverage ratio for American Capital Agency is 2.14 times. This reflects that all these companies have enough resources to cover their dividend distributions through their cash from operating activities.
The stocks of non-agency mortgage REITs being considered are trading at significant premiums to their book value when compared to the relative valuations of the Agency mortgage REITs. The stock of American Capital Agency trades at a premium of 12%, while the stock of Annaly Capital Management trades in line with its book value. However, the stocks of PennyMac and Newcastle trade at 30% and 115% premiums to their respective book values.
In conclusion, we believe if the Fed accelerates bond buying and the mortgage rates decrease further, American Capital Agency will be least affected among the Agency mortgage REITs, while PennyMac and Newcastle would not be adversely affected by accelerated prepayments. Therefore, the three are our favorite stocks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.