In Favor Of Hybrid Mortgage REITs

Includes: AGNC, MFA, NLY, TWO
by: Bear Fight

Doubleline is an asset management company formed by bond veteran Jeffrey Gundlach, and in his "must-listen-to" quarterly update call, Gundlach covered many topics, including his view of the economy, securities markets and political system. The company's flagship Total Return Fund is run by Gundlach, and he has outperformed the bond and mortgage market in recent years and has been dubbed the King of Bonds.

Bluntly, Gundlach believes this is a bad time to put money into risk assets. Gundlach uses a combination charts and artful prose to communicate his views. While Gundlach remains cautious on markets overall, Doubleline has historically been a buyer of distressed non-agency securities. Approximately 31% of the Total Return Fund is invested in non-agency MBS.

While Gundlach has warned investors about the rising risk of prepayments to the mortgage REIT space, Doubleline has focused on insulating its funds from prepayments by purchasing securities that will benefit from prepayments. The average price of the securities in his Doubleline total return fund is $96.94, meaning that a pick-up in refinancings at par will benefit Doubleline.

Agency REITs including Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) invest in government guaranteed mortgage backed securities. Both large capitalization mortgage REITs have acquired portfolios with securities above par, which introduces risk to refinance. In the quest for yield, these managers have purchased bonds above par.

As opposed to agency REITs, hybrid REITs invest in both agency and non-agency securities. Hybrid REIT managers have the flexibility to move between agency and non-agency securities to find the best risk/reward for shareholders. Non-agency bonds trade more like equities as opposed to solely being driven by interest rate risk.

Hybrid REITs

Investors can benefits from hybrid REITs as managers can move between agency and non-agency securities to provide investors the best risk adjusted yield. Two that investors should investigate are MFA Financial, Inc. (NYSE:MFA) and Two Harbors Investment Corporation (NYSE:TWO). For instance, both TWO and MFA have used the ramp in non-agency prices in 2012 to lighten up on non-agency portfolios. Conversely when non-agency securities declined in mid to late 2011, these managers were picking up bonds at strong risk adjusted pricing.

MFA is an internally managed REIT and its management team believes there are significant opportunities within the non-agency RMBS space. Since January 2000, MFA has provided investors with annual returns of 14.5%, far outpacing the S&P 500.

Prepayment Risk

A key risk for mortgage REITs is prepayment risk. As rates decline, borrowers refinance loans into lower rates, which impact mortgage REIT earnings. After the credit collapse, hybrid mortgage REITs, including MFA, purchased non-agency mortgages at discounts to par. In the most recent reporting period MFA owned over $4 billion of non-agency MBS at an average cost of $0.73. As refinancing on these securities increases, MFA realizes more than its average cost. The table outlines the increase in yield when speeds increase. MFA management believes the company can generate 7.3% loss adjusted annual unlevered yields on non-agency securities.

Conversely, agency mortgage REITs including Annaly and American Capital Agency, which have an average cost of over $1.00 can experience loss on securities as refinancing increase. If an investor pays $1.04 for a face value security of $1.00 and the security is refinanced the investor will lose $0.04.

Hybrid Mortgage REITs

Two Harbors Investment Corp.

  • Market Capitalization: $1.7 billion
  • Dividend Yield: 16.1%
  • Price to Book Value: 1.1x
  • Leverage: 4.5x

MFA Financial, Inc.

  • Market Capitalization: $2.7 billion
  • Dividend Yield: 13.3%
  • Price to Book Value: 1.0x
  • Leverage 3.5x

Agency Mortgage REITs

Annaly Capital Management

  • Market Capitalization: $16.0 billion
  • Dividend Yield: 13.8%
  • Price to Book Value: 1.0x
  • Leverage: 5.4x

American Capital Agency

  • Market Capitalization: $6.7 billion
  • Dividend Yield: 16.7%
  • Price to Book Value: 1.1x
  • Leverage: 7.6x

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.