Are Rising Interest Rates Good Or Bad For mREITs? Duration Is The Key

by: Lance Brofman

The market has judged rising interest rates to be very bad for mREITs. If you ask the question: are falling gold prices good or bad for jewelry companies like Tiffany & Co. (NYSE:TIF) or Signet Jewelers (NYSE:SIG), you would get a more nuanced answer. Lower gold prices would lower the raw materials costs for jewelry companies. That would allow them to increase their profits either from selling products at the previous prices with higher profit margins, lowering prices and selling more jewelry or a combination of both.

The downside of lower gold prices for jewelry companies is that the value of their existing inventory declines. Possibly a jewelry company that had a very large inventory of finished goods or work in progress, that was financed with borrowed money might go bankrupt as a consequence of a sharp decline in gold prices. This is not a bad analogy for mREITs. An increase in long-term interest rates could increase mREITs' earnings from the spread they earn from mortgage securities financed with borrowed money. However, the value of their inventory of mortgage securities declines as long-term interest rates rise. If they are leveraged too much and the decline in the value of their inventory is too rapid and severe, they could suffer the same fate as an overstretched jewelry company stuck with too much gold in a collapsing market that might not be able to rollover its loans.

Recent market action in the baskets of mREITs such as ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (NYSEARCA:MORL), Market Vectors Mortgage REIT ETF (NYSEARCA:MORT) and iShares Mortgage Real Estate Capped ETF (NYSEARCA:REM) suggests that the market is ignoring the possible higher earnings and dividends that can result from the higher yielding mortgage securities mREITs could buy. Alternatively, the markets might not believe Ben Bernanke's assertion that short-term rates will remain low for an extended period. The market appears to be focusing on the impact on the mREITs' book values from the sharp increase in long-term rates that has occurred and the possibility of even higher future long-term rates.

There has been much speculation on the extent that the decline in mortgage securities' values has impacted the book values of mREITs. The agency mREITs use hedges to mitigate the impact of higher interest rates on their portfolios. The markets seem to be dubious as to the efficacy of the hedging in protecting the book values from the impact of the rise in long-term interest rates.

The tool used to estimate the impact of a change in interest rates on the value of a mortgage portfolio is duration. In the 1930s, Frederick Macaulay realized that the weighted average of the times of cash flows for a bond, which he named duration, could indicate how much a bond would change in value in response to a change in interest rates. A fixed-income security with a duration of one year will increase in value by 1% if interest rates decline by 1% or decline by that amount if rates rise by that amount. A fixed-income security with a duration of 5 years will increase in value by 5% if interest rates decline by 1% or decline by 5% if rates rise by 1%. The change in value does not directly depend on the level of interest rates. Thus, a bond or a portfolio of fixed-income securities portfolio with a 5 year duration will decline by the same 5% if interest rates are 3% and increase to 4% or if interest rates are 13% and increase to14%.

Many agency mREITs disclose estimates of their duration both for their total mortgage assets and for the net duration of their portfolio after considering the effects of their hedges and liabilities. American Capital Agency Corp. (NASDAQ:AGNC) presenting at the Morgan Stanley (NYSE:MS) Financials Conference on June 12, 2013, indicated that on June 7, 2013 the duration of their mortgage assets was 5.2 years and the duration of their hedges and liabilities was -4.5 years for a net duration of 0.7 years. At that time AGNC indicated that a 100 basis points rise in rates would increase the net duration to 1.2 years and that a 200 basis points rise in rates would increase the net duration to 1.3 years. Also presenting at the Morgan Stanley Financials Conference, Amour Residential REIT (NYSE:ARR) indicated that on June 7, 2013 the duration of their mortgage assets was 5.1 years and that after considering the duration of their hedges they had a net duration of 1.7 years.

CYS Investments, Inc (NYSE:CYS) at the Deutsche Bank (NYSE:DB) dbAccess Global Financial Services Investor Conference on June 5, 2013, referred to their March 31, 2013 10-Q filing, which included a table that indicated the duration of their mortgage assets was 3.3 years, and after considering the duration of their hedges, they had a net duration of 1.9 years.

The price movements in AGNC, CYS and ARR could suggest that market participants are either ignoring what AGNC, CYS and ARR say their durations are or that they think AGNC, CYS and ARR are outright lying.

Duration calculations for mortgage securities and portfolios of mortgage securities are complex and different methods of calculation can yield different results. The complicating factor for mortgage securities is that unlike a plain bond, changes in interest rates also change the weighted average of the times of cash flows for a mortgage security. An increase in interest rates makes it less likely that homeowners will refinance their mortgages. Refinancing causes the mortgages to prepay principle, which speeds up the cash flows. A decline in prepayment speed increases the yield to maturity of a mortgage security trading at a premium as it extends the period over which principle will be repaid. For a mortgage security trading at a discount, declines in prepayment speed decreases the yield to maturity. This convexity of extension risk means that the duration of a mortgage security can increase rapidly as the market price of the security declines below par.

A further complicating factor is that many models used to calculate duration of mortgage securities and hedges assume parallel movements in interest rates. That is both short-term and long-term interest rates moving up or down by the same amount. In recent months, long-term rates have increased while short-term rates have not. Some types of hedges like a short position in Eurodollar Futures would not provide much of an offset to higher long-term rates in a period of stable short-term rates.

Even given the various caveats regarding mREIT duration calculations, if the durations claimed by the agency mREITs are anywhere near accurate, those who have been negative on the sector will be in for a very big surprise when the actual book values of the mREITs are reported. One possibility is that the agency mREITs are now trading at deep discounts to book value. That could be because markets are pricing in extreme future increases in interest rates or the possibility of a witch-hunt type hysteria developing on the part of regulators or the media regarding mREITs, similar to what occurred in the 1990s regarding derivatives such as inverse floaters. See: Are mREITs The New Inverse Floaters?

Rising short-term rates are unambiguously bad for agency mREITs and just about everyone else. The only people who clamor for higher short-term rates now are those concerned about the inflation that has not occurred yet and some who advocate the position that savers are being cheated by the low short-term rates. They apparently believe that people who put their money in risk-free assets such as treasury-bills, insured savings accounts and money market funds are entitled to significant returns without taking any risk even if it comes at the expense of the rest of the American taxpayers who would pay the higher rates on those as treasury-bills.

As I discussed in: Federal Reserve Actually Propping Up Interest Rates: What This Means For mREITs, an increase in long-term interest rates can be beneficial for agency mREITs as spreads and earning can increase. At the Investor Conference on June 5, 2013 CYS actually stated that they wanted interest rates to go up as long as they do not rise too quickly.

Whether rising interest rates are good or bad for investors in mREITs depends on the investor's objectives and holding periods. For short-term traders, unless market perception changes from its present view with regard to the impact of interest rate changes on mREITs, higher long-term rates are negative for mREITs. For longer-term agency mREIT investors, higher long-term rates can actually be beneficial. As I explained in: A Depression With Benefits: The Macro Case For mREITs, an investor who bought MORL at the all-time high price of $32.25 on April 12, 2013 with the intention of holding for ten years and reinvesting all dividends during that period could in a sense be better off now as a result of the carnage in the mortgage markets. Investors who buy agency mREITs with the intention of holding for a relatively long period, reinvesting the dividends and making periodic additional investments should actually welcome higher long-term interest rates.

Disclosure: I am long CYS, ARR, AGNC, MORL. 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.

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