Agency Mortgage REITs Are Going On Sale This Summer

by: Zvi Bar

Agency mortgage REITs are now in a correction phase due to concerns about interest rates and other factors. In the summer of 2012, there was a growing likelihood that agency mortgage REITs would soon enter a period of market underperformance along with most government related income instruments. In the fall of 2012, trends worsened for the sector, including rising retail investor allocations into mREITs and mREIT ETFs, and accelerating prepayment rates on mortgages due to historically low rates. I believe that these issues and rising interest rates are now taking mREITs to better valuations, and long-term income investors should consider accumulating agency mREIT allocations on continued weakness, with the understanding that continued weakness is probable.

Agency mortgage REITs hold portfolios made up of residential mortgage backed securities that are insured by federal agencies such as Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), which come with an agency backing and an implied U.S. government backing. Most agency mREITs leverage their agency RMBS portfolios 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 were recently set to yield somewhere between 10 percent and 15 percent, and had leverage rates roughly between 5-8x.

The largest and best-known agency mREITs are American Capital Agency Corp. (NASDAQ:AGNC) and Annaly Capital Management, Inc. (NYSE:NLY), while the largest mortgage REIT Index ETFs are iShares FTSE NAREIT Mortgage REITs Index ETF (BATS:REM) and the Market Vectors Mortgage REIT Income ETF (NYSEARCA:MORT). Both ETFs also hold non-agency and commercial mortgage REIT exposure. Annaly actually just made a transformative acquisition of Crexus, a former commercial mREIT that it managed and partially owned, making Annaly a hybrid mREIT (but still one of the largest publicly traded portfolios of agency paper).

Recently increasing interest rates and the last several quarters of accelerating prepayment rates have caused many investors to sensibly gain a fear of declining future margins and declining book valuations for agency debt in accordance with any future interest rate increases. This has made agency mREITs and the abovementioned ETFs exceptionally poor performers over the last few weeks. The devaluation appears likely to continue, especially as entities report their changes to book valuation.

The concern at this point is that these reasonably highly leveraged entities will suffer substantial declines to their book valuations and spreads, which will also require dividend cuts. All of this appears probable, and current purchasers are evaluating these entities on old news. Book value is reported on a quarterly basis, with most mREITs likely to report their Q2 2013 numbers in July. This means these mREITs are being evaluated with old book valuations and that many investors will be surprised by the size of the declines to book value during the second quarter.

Evaluating agency mREITs is different than most equities. First, they are REITs, and have highly different characteristics compared to a traditional corporation, including that at least 90% of earnings must be distributed and that those dividends are taxed as income and not at the lower rate presently applied to corporate dividends. Also, these entities are essentially leveraged bets on government debt. They have relatively low sensitivity to most things that don't involve some government agency, including that both their cost of product and capital are set by the interest rates on U.S. debt.

Since the end of the first quarter of 2013, the performance of 10-20 year government debt is down nearly 9% and agency debt of similar maturity declined by a roughly similar rate. Mortgage REITs have leveraged sensitivity to these moves, and usually attempt to hedge against violent fluctuations. Nonetheless, that leverage should cause their portfolios to decline to a greater degree than did the underlying debt. As a result, AGNC has declined by about 37%, or roughly 4x sensitivity to the 10-year, and NLY declined by about 27%, at roughly 3x. Some of Annaly's exposure should have been mitigated by its Crexus acquisition, but commercial debt was also affected.

Peaking valuations for these agency mREITs followed peaking dividend payouts by them, and the vast majority of agency mREITs have reduced their payouts over the last year. For example, AGNC reduced its dividend last quarter and at the start of 2012, while NLY reduced its dividend twice in each of the last two years and once so far in 2013. Even as spreads narrowed and dividends declined, investors continued to pile into mREITs because their book values were appreciating. Much of these book value gains were composed unamortized net premiums on the agency debt. Mortgage bond investors risk losses when buying debt for more than par, or the bonds call rate if above par.

The unamortized net premium can best be described as the price above that reasonably expected call rate at which the debt is being valued, and, therefore, the potential losses to be realized if all of a portfolio's agency debt was called. At the end of the first quarter of 2013, AGNC's unamortized net premium balance declined by $600 million, to $3.8 billion, and that valuation essentially evaporated from the portfolio. Similar premium losses should be expected, and though recently rising interest rates should reduce the calling of agency debt due to the greater refinancing expense, those higher rates will also reduce a portfolio's level of unamortized net premium.

It is generally better to buy something on sale, but there is also the potential for a perceived sale to be illusory. For example, book values are listed for these companies based upon data from the end of Q1 of 2013, but most of these book values are probably lower at the moment. Most agency mREITs report Q2 results next month, meaning that we will not get information on where book values were two weeks ago until about four weeks from now. Because book valuation is generally at the core of agency mREIT evaluation, it is difficult to evaluate market price for a portfolio of agency debt, especially when held at a moving rate of leverage. Current prices indicate these mREITs may not be trading at an actual discount, or at minor discounts if they are, despite appearing to trade 20-30 percent below last quarter's book values.

Those mREITs that proactively reduced their leveraged exposure and use this recent and ongoing move as an opportunity to acquire higher yielding debt than they otherwise would have may do well in this market over-run by sellers. Despite anticipations of reduced intervention, the Federal Reserve appears unlikely to stop acquiring agency debt within 2013 and possibly 2014, and has also indicated plans to not sell the agency paper it acquired. Though interest rates will likely eventually increase, the rate of increase is unlikely to remain as dramatic as it has been over the last few weeks. If anything, rates continuing to move at this speed will forebode further intervention to mitigate that pace.

Later this month, I will put forth my method of evaluating publicly traded agency mREITs and comparing these entities. The method is best applied when reviewing coming Q2 reports, though it could be applied to prior numbers with the understanding that existing market data is somewhat obsolete. In the interim, investors should understand that agency mREITs are going to continue moving in an opposite direction to treasury rates.

Until these mREITs report updated book values, spreads and leverage rates, it will be exceedingly difficult to properly evaluate these entities. Simply put, and especially due to the recent volatility, Q1 information is too out of date to be helpful. This uncertainty could also weight down shares, though it is equally possible that the lack of clarity will lure many to invest at what already appears to be a bargain basement price. Nonetheless, quarterly reporting, in about four weeks, will likely catch many investors and analysts by surprise.

Accumulating agency debt and/or agency mREITs in small batches on any continued and probable weakness this summer, and especially around any misunderstood forthcoming reports, should provide investors with a meaningful long-term income allocation at a far better than average price. Exposure to agency mREITs should be limited to a reasonable percentage of a portfolio's income production allocation, based upon the investor's risk profile, time-horizon, income needs and other investments. Additionally, mREIT dividends are taxed as regular income and not at the lower corporate dividend rate, making them generally better performing investments when held within tax deferred or exempt accounts.

Disclosure: I am long NLY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.