Agency mortgage REITs have been among the better performing asset allocations since the financial crisis hit the world in 2008 and 2009, but they have fallen on tough times in the last few months. Agency mortgage REITs hold portfolios composed exclusively of residential mortgage backed securities that are insured by federal agencies, which means they come with an agency backing and an implied U.S. government backing. This has made these agency mREITs safe, and allowed them to both appreciate and provide a high yield to investors.
Rising interest rates and prepayment concerns are risks to holders of agency residential mortgage backed securities and these agency mREITs. Most investors allocate to agency mREITs for the income. These REITs leverage their assets in order to multiply the return made on the spread, or margin, between their borrowing costs and the interest paid on the portfolio of agency-backed RMBS that they hold. Most agency mREITs now yield somewhere between 11 and 16 percent, which means that these mREITs offer quarterly payouts that are comparable or superior to the annual yield of a 10-year treasury or the S&P 500.
Prepayments have been on the rise, causing many investors to fear declining spreads and book values for these agency mREITs. During Q3, mortgage prepayment rates hit their highest levels since before the subprime crash, fueled by homeowners continuing to refinance with borrowing costs hovering around historic lows. Most existing agency-backed mortgages and RMBS trade at a premium. Mortgage bond investors risk losses when buying debt for more than par or whatever its call rate may be if above par. These concerns have helped drive down mREITs.
Another major concern is the coming debt ceiling debate. Agency-backed paper is in many ways like a quasi-treasury. Anything that will change the interest rates or credit rating of U.S. debt will have a similar effect upon agency debt. In the summer of 2011, when the debt ceiling was last at issue, mREITs faced some significant declines. Those mREITs quickly rebounded from those declines, but a different resolution to the situation could have caused them to fall even further.
Recently most agency mREITs have been declining, as prepayments rise and the debt ceiling approaches. See the below one and three-month charts of the performance of some of the largest agency mREITs, American Capital Agency Corp. (AGNC), Annaly Capital Management, Inc. (NLY) and CYS Investments (CYS), as well as two popular mortgage REIT Index ETFs. iShares FTSE NAREIT Mortgage REITs Index ETF (REM) and the Market Vectors Mortgage REIT Income ETF (MORT). Both ETFs also hold non-agency and commercial mortgage REIT exposure.
In reaction to recent declines and/or expected further declines, several agency mREITs, including NLY and AGNC, the two largest and most liquid agency mREITs, have recently announced stock repurchase plans. Due to prepayments and the high dividend payouts that the REIT model necessitates, mortgage REITs usually go to the market and sell additional shares through secondary stock offerings, which is essentially the very opposite of what they are now doing.
This could mean that these agency mREITs believe the market is not appropriately evaluating their books, or that it is overvaluing those available on the open market. These REITs may have also simply come to the conclusion that acquiring more agency paper is too risky in advance of the debt ceiling, and its potential to devalue all agency paper.
Given the use of leverage, generally at rates between 5x and 8x the market valuation of these REITs, there is the potential for these companies to sustain losses that are more substantial than that which the underlying agency paper might. Such declines could be temporary, if triggered by what turns out to be a temporary debt-ceiling crisis, or the disclosure of pre-existing prepayment. If that were to be the case, these repurchase plans could help management make opportune acquisitions.
Owing to the risks associated with agency mREIT leverage and potential peaking of treasury valuations, exposure to the asset class should be limited to a reasonable percentage of a portfolio based upon an investor's risk profile, time-horizon, income needs and other investments. Additionally, most REIT dividends are taxed as regular income and not at the lower corporate dividend rate, making them substantially better performing investments when held within tax deferred or exempt accounts.
Disclosure: I am long NLY.