In this article, I will be discussing my top picks within mortgage-backed REITs for 2015. I will be discussing a pure play agency RMBS company and a Hybrid company. I believe interest rates will remain low for longer than expected by the market; the pure play agency mortgage has positioned its portfolio to benefit from the low interest scenario. Furthermore, it is also looking to diversify its portfolio to reduce dependency on the agency market. The hybrid company already has a well-diversified portfolio with significant exposure on the credit side. It also has diversified its liability side and reduced its dependence on the repo market.
Why Interest rates will remain low?
Analysts who support the idea that the Fed will soon raise interest rate are basing that opinion on the improvement in the U.S. job market. It is beyond any doubt that the U.S. job market has shown significant improvement in the last six months, with more than 200,000 job additions each month. The unemployment rate also fell down to 5.8%, which is encouraging for the economy. Slacks in the labor market also improved in the past six months or so, but they are nowhere close to the pre-recession levels, or the Fed's expectations.
The Fed identified two slacks in the labor market i.e. the labor force participation rate and the growth rate in wages. In November, the labor force participation rate stood at 62.8%, just 10bps higher than the lowest level since 1978, as shown in the figure below.
Source: Trading Economics
Similarly, the average wage rate increased by $0.09 per share in November; this translates into an increase of 2.1% from a year ago. However, there are four issues with this number and resultantly the argument arises that $0.09 per share is not enough to raise interest rates. Firstly, economists are predicting that the Fed is trying to bring the annual increase in wage rate to 3% before raising interest rates. Secondly, the inflation rate is at 1.3%, which means real growth in wages is very low. Thirdly, the average work week also rose to 34.6 hours, which is almost at the highest level since 2008. Lastly, there is massive income inequality in the U.S., as shown in the figure below. The top 3 percent enjoys more than 50% of total wealth, whereas the bottom 90% has less than 25% of the wealth. If we look at the graph below, income inequality has been on the rise from the last 3-4 years. The same concern was also raised by Janet Yellen a few months back in her speech in Boston.
Source: Federal Reserve Bulletin
Furthermore, inflation is significantly below the Fed's target of 2%. The Fed has lowered its inflation expectations to 1%-1.6% in 2015. Lower oil prices will further pressurize the inflation outlook for the economy. Similarly, the global macroeconomic environment is not stable, and foreign economies slowing down will adversely impact the U.S. So, I believe the Fed will keep rates low as long as the impact of the recession is not completely eliminated from the economy. An early end of the expansionary monetary policy could eventually force the Fed to cut rates back to zero. In the recent December meeting, the Fed assured that it would be 'patient' and the rise in rates would be dependent on economic data rather than a calendar date.
Top RMBS Companies
American Capital (NASDAQ:AGNC)
In the pure play agency RMBS segment, my top pick is AGNC. The company has been aggressively positioning its portfolio from the beginning of the year and has managed to take advantage of the low interest rates. The company has taken two strategic initiatives. Firstly, the management has reduced its hedged portfolio. In the first three quarters of the year, the management reduced its hedged positions by almost $9.35 billion to $48.3 billion. Secondly, the management has increased its allocation to high-yielding 30-year MBS. By the end of the third quarter, the investment in 30-year MBS reached $45.2 billion (65% of the portfolio) in comparison to $29.3 billion (43% of portfolio) in the last quarter of the previous year. Most of this increase comes as a result of the expense of 15-year MBS. Both these moves helped the company boost its core EPS; AGNC's core EPS and dollar income is $0.19 per higher than its quarterly dividend.
AGNC is also looking to diversify on the non-agency side. The management is looking to make investments in senior tranches of the subprime and jumbo loans. Furthermore, the company is also interested in investing in mortgage servicing rights (MSR), which act as a natural hedge against the rising rates. These initiatives don't only improve the net interest spread for the company, but also help the company trade at a premium to its book value, as it will not remain a pure play RMBS company.
TWO Harbors (NYSE:TWO)
My top pick among hybrid RMBS companies is TWO. My bullish thesis on the company is based on two key factors. First of all, the company has a well diversified portfolio with significant investments on the credit side, which offer the higher net interest spread. On the rates side, the company invests almost 47% of the total portfolio in 30-year MBS. TWO also invests in MSR, which offers the highest yield on the rates side, but also act as a natural hedge against rising rates. On the liability side, the company has access to less costly FHLB funds. They also have higher duration than the repo funds, which reduces the risk of asset liability mismatch. TWO has access to $2.5 billion of FHLB funds, which reduces its dependency on the repo market.
Secondly, TWO is trading at a P/BV of 0.90x, which is not justified for a hybrid RMBS company with a well diversified portfolio. It should trade at premium valuations, which means we can expect significant price appreciation of 13%, calculated in my previous article on the company.
I expect rates to remain low longer than anticipated by the market due to the slacks in the labor market, lower than expected inflation, and global economies slowing down. I expect AGNC will continue to take advantage of the low interest rate and adjust its portfolio accordingly when the rates finally rise. On the other hand, TWO has a well-diversified portfolio, with the potential for significant price appreciation.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.