Earlier in the second quarter, I wrote an article comparing Mortgage Real Estate Investment Trusts (mREITs). Now that earnings reports have come in, it's time for another look at what the mREITs have done during a very volatile time. The second quarter of 2013 saw rapidly rising rates (10 year treasury yields went from 1.83% to 2.49%) and falling Mortgage Backed Securities (MBS) prices (3.5 coupon 30 year fixed MBS went down 4.5% in value, a more thorough breakdown of price changes in MBS and swaps is available here). The mREITs had a difficult quarter because of this. Price to book values went down significantly. When earnings reports came out for Q2, we saw that much of the price decline was justified from the large book value losses that were reported. The mREITs are still trading at a hefty discount to book value in Q3 as fears linger about rising rates. mREITs responded to rising rates in Q2 by taking a defensive position. This was done by lowering leverage and increasing hedges. (There are some exceptions to these trends among the mREITs that will be outlined below.) There is some good that comes with higher rates, the companies have the potential to capitalize on the new higher coupon MBS by using their cash flows or by increasing leverage to buy them. None of the fears of margin calls or lack of liquidity or lack of repo borrowing offers have been realized. This article will attempt a risk benefit analysis of 10 of the mREITs with a companion article by Darron McCammon who will cover 9 more of the mREITs.
Below are 3 charts outlining the reward, risk, and dividend sustainability analysis. (*reward, book risk and dividend risk ratings are the subjective opinions of the author and factor in not only the data presented but prior history and confidence of the author in management)
|Symbol||Discount to Q2 book||Yield||Potential Economic Value (Yield + discount to book)||Reward Rating *|
|Symbol||% Portfolio not hedged||Duration Gap||Leverage||Book Risk Ratings *|
|IVR||18%||1 to 1.5 target duration||7.6||B|
|Symbol||Q2 Taxable Income / Q2 Dividend||Undistributed Taxable Income||Q1 Net Spread||Q2 Net Spread||Spread % change in Q2||Dividend Risk Rating *|
|WMC||104%||-36.6 cents / -40/6% of dividend||2.17||2.18||.5%||C|
23.5 cents / 34% of dividend
|ARR||86%||35.7 cents / 170% of dividend||1.35||1.38||2.2%||A|
|AGNC||99%||1.07$ / 102% of dividend||1.71||1.59||-7.0%||B|
|MITT||103%||1.78$ / 225% of dividend||2.25||1.96||-12.9%||A|
|AMTG||84%||-59.5 cents / -85% of dividend||2.8||2.1||-25.0%||D|
|CYS||108%||-2.58$ / -758% of dividend||1.16||1.36||17.2%||B|
|IVR||91%||11 cents / 16.9% of dividend||1.64||1.59||-3.0%||D|
|MTGE||95%||43 cents / 54% of dividend||2.09||1.96||-6.2%||C|
|HTS||94%||25 cents / 35% of dividend||1.11||.93||-16.2%||C|
|NLY||118%||14 cents / 35% of dividend||.91||.98||7.7%||B|
|AI||128%||41 cents / 47% of dividend||1.9||1.45||-23.7%||B|
|EFC||64%||89 cents / 116% of dividend||4.66||4.72||1.3%||A|
|DX||117%||10 cents / 34% of dividend||1.89||1.75||-7.4%||A|
|TWO||68%||39 cents / 125% of dividend||2.5||2.9||16.0%||B|
|86%||-6 cents, however there is a lot of 2012 UTI||2.32||2.38||2.6%||A|
|CMO||68%||-4 cents / -13% of dividend||1.15||1||-13.0%||B|
|NRZ||214%||8 cents or 114% of dividend||No info||A|
Western Asset Mortgage
[69.7% 30 year fixed MBS, 18.7% 20 year fixed MBS, 4% Non Agency MBS, 7.2% IO and IIO]
Loss in economic value in Q2 was -5.8% (book value drop with dividend paid added in). WMC believes that volatility will not be as high as Q2 for the rest of the year. At the end of Q2, held $500 million in short TBA positions in order to profit from drop in value of MBS. They continue to receive offers to expand the repo lines. They adjusted swap and swaption positions in Q2 as the volatility increased or decreased, and are replacing some swaptions with swaps after Q2 end because they are cheaper. Sold some low coupon, added higher coupon MBS. Focusing on low pay ups for MBS at the moment. They expect Q3 spreads to be in 2.2 - 2.4 range.
[86.9% Agency MBS, 13.1% Non Agency MBS]
Loss in economic value in Q2 was -14.1%. Management is essentially the same as ARR. They have a small amount of non agency MBS and some hedging, but remain vulnerable to rising rates.
Armour Residential REIT
[100% Agency MBS]
Loss in economic value in Q2 was -15.7%. Management did not buy more hedging in Q2 despite the need for it. They adhere to their plan as outlined in their monthly reports, but could benefit from more active management.
American Capital Agency
[55% 30 year fixed MBS, 42% 15 year fixed MBS, 3% mix of 20 year fixed MBS, ARMs, and CMOs]
Loss in economic value in Q2 was -8.2%. Believe MBS supply will be lower due to increase in mortgage rates and continued FED buying, which may recover prices in MBS. Choosing risk management over earnings in the near term. They expressed uncertainty about rate direction. Pay up exposure (paying more than face value on a MBS) is no longer significant (less than 2.5% hit to book value if payups at zero). Dropped portion of 30 year fixed MBS in portfolio from 64% to 56%. Increased 15 year fixed from 34% to 42%. 15 year fixed are easier to hedge, benefit from FED involvement, and are shorter in duration than 30 year fixed. Reduced spread risk and interest rate risk and are in a defensive position. Terminated some short term swaps and added long term swaps.
AG Mortgage Investment Trust
[68% Agency MBS, 24% Non Agency MBS, 8% CMBS, IO, ABS, Commercial Loan]
Loss in economic value in Q2 was -11.2%. Reduced the size of the portfolio (from $6.3 billion to $5.6 billion) and increased the amount of interest rate hedges (from $2.7 billion to $3.7 billion). Backpedaled on their Q1 statement that the dividend is safe for all of 2013 and stated that going forward the dividend will depend on earnings. Increasing whole loan holdings. Turned defensive in Q2 and are better prepared for rising rates. Have to pay out $1.78 in UTI by September 15th, 2014.
Apollo Residential Mortgage
[50% agency RMBS, 26% non-agency RMBS, 5% securitized loans and 19% cash]
Loss in economic value in Q2 was -11%. Reduced leverage, sold MBS, and bought longer dated swaps. Shifted more of portfolio to non-agency MBS. No straight answer on dividend sustainability question during the conference call.
[46% 30 year fixed, 33% 15 year fixed, 15% Hybrid ARMs, 6% 20 year fixed]
Loss in economic value in Q2 was -18.1%. Bought more 30 year and sold some 15 year MBS. Positioned for rates being stable or lowering. They increased the dividend in Q2, one of the only mREITs to do so. As they did not materially increase their hedges or the hedge duration in Q2, this puts them at odds with the majority of mREITs. So far in Q3 rates have remained stable but with QE3 taper on the horizon, CYS's portfolio position makes this stock a risky bet. They think the taper is already priced in and may get hurt by that assumption.
Invesco Mortgage Capital
[63% Agency MBS 17.5% Non Agency MBS, 11.8% CMBS 7.5% Other]
Loss in economic value in Q2 was -9.3%. Increased length and amount of swaps and swaptions. Reduced agency MBS holdings. CMBS holdings declined in value in Q2. Increased Commercial real estate mezzanine loans. Didn't reinvest cash flow to agency MBS in Q2; they added cash as a cushion instead. Stated in the earnings call that it takes time to increase spread when rates rise and that core earnings are lower in Q3 so far. I'm expecting a dividend cut in IVR in Q3.
American Capital Mortgage
[62% 30 year fixed, 26% 15 year fixed, 11% Non Agency, 1% 20 year fixed]
Loss in economic value in Q2 was -9%. Reduced size of portfolio and increased hedges. Taxable income in Q3 warned to be lower. Bought 5% of their own stock in Q2. Very defensive hedging position at 106% hedged. Got rid of their TBA positions in Q2.
[89% ARMs (66% of those have 4 or more years to reset), 11% 15 year fixed]
Loss in economic value in Q2 was -18.8%. Huge book value drop (-21.3%) and increased leverage to 9.3x should make every investor more cautious. A large chunk of their portfolio was (and still is) longer dated hybrid ARMs that had a big sell-off in June. Added a billion in eurodollar futures hedges that worked well for Arlington Investments in Q2.
The individual company write-ups on the last 9 names in the chart (NLY, AI, EFC, DX, ANH, TWO, MFA, CMO, NRZ) can be found in the companion article linked above.
There are other mREIT stocks such as EARN, CIM, NYMT, NRF, NCT, PMT, OAKS, and RWT which you may wish to consider but we were not able to incorporate this time around.
The third quarter to this point has seen low volatility in terms of rates (10 year treasury yields have gone from 2.48% to 2.60%) and that has been a welcome reprieve for the mREITs; however the volatility in MBS prices may not be over. I predict the start of QE3 tapering will cause at least a few bad days if not weeks for MBS prices and mREITs. The defensively postured stocks will be better able to protect their book value in this environment. The lowered leverage and increased hedges are cutting into the earnings mREITs pay the dividend with, but the increasing spreads in some companies may make up for that. I expect some dividend cuts in Q3 from the more defensively positioned mREITs. If volatility in rates stays low, the mREITs would be able to lever up again and lower their hedges somewhat. It is a historically low price to book value environment in the mREITs and it may be a good time to buy some of them, however it may take QE3 tapering to blow over before we see a return to even in price to book values. Waiting to buy until the QE3 taper begins is a strategy that avoids that risky event but could make you miss out on some dividends if tapering begins after the Q3 ex-dividend dates in September. I have divided the stocks we analyzed into buy, hold, or sell categories:
Buy: AGNC, MTGE, MITT, AI, EFC, NRZ
Hold: WMC, AMTG, IVR, NLY, DX, ANH, TWO, MFA, CMO
Sell: HTS, ARR, JMI, CYS
Disclosure: I am long WMC, TWO, NRZ, NRF, NCT, AMTG, MTGE, 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.
Additional disclosure: MORL holds a majority of the mREITs in its index.