Annaly Capital Management (NYSE:NLY) is one of the largest mortgage REITs and is one investors should follow to get a feel of the sentiment for the sector in general. While mortgage REIT prices are not entirely efficient, NLY is less absurd than the other mortgage REITs. In a nutshell, the most efficient market prices are generally going to the largest mortgage REITs and it seems to help some if the mortgage REITs' positions are "easier" to analyze.
What Is Not The Culprit?
The culprit for the sudden fall in share prices is not agency MBS and it shouldn't be swaps unless the swap rate became dramatically desynchronized from its recent relationship to treasury securities of the same maturity. Before starting this article I took a look at the movement in treasury rates and MBS prices. Treasury yields are moving by around 1 basis point to 4 basis points so far in the day. That isn't too big of an issue. The agency MBS are also up slightly on the day. Their price gains aren't quite as large as treasuries but overall there isn't too much change in the bonds.
What Is the Culprit?
The biggest problem for Annaly Capital Management right now is the way correlations have been working across asset classes. While Annaly Capital Management climbed with a high correlation to the SPDR S&P 500 Trust ETF (NYSEARCA:SPY), that correlation has started to break down materially over the last month.
However, a little comparison of several assets that should demonstrate what is happening:
NLY is the lighter blue line and is down the hardest on the day. While I have been arguing that mortgage REITs are overvalued lately, I would have expected a more identifiable cause to send NLY falling so hard. Since it can be a barometer for the sector, I'm keeping an eye on it.
American Capital Agency Corp. (NASDAQ:AGNC) is the yellow line and it is down about 1.2%. The iShares Mortgage Real Estate Capped ETF (BATS:REM) is the red line. The top holdings in the ETF are Annaly Capital Management and American Capital Agency Corp. I want to keep a close eye on the correlation with share prices there as well. There have been times when a mortgage REIT ETF moved away from the price movements of the underlying assets for a few hours. The divergence in prices between the ETF and the share prices indicates a correction coming soon.
The green line is Two Harbors Investment Corp. (NYSE:TWO). TWO runs lower leverage and emphasizes credit risk in their portfolio as the way to drive returns. When the broad market is selling off and credit spreads are widening it should lead to TWO underperforming agency mortgage REITs like AGNC. TWO being higher than AGNC on the day suggests price movements are heavily fueled by emotion.
NLY's portfolio demonstrates some credit risk but the huge allocation is still to agency MBS. I would expect NLY to be between AGNC and TWO.
The purple line is the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK) and the dark blue line is the iShares 7-10 Year Treasury Bond ETF (NYSEARCA:IEF). These are both very liquid ETFs so the spreading in their share prices is a quick way to approximate the market's perception of credit risk. If JNK is underperforming IEF it means the credit spreads are expanding. The maturity of the bonds isn't a perfect match but the weighted average maturity of the bonds in JNK is almost 7 years so the comparison is good enough for establishing rough approximations of market sentiment.
Based on movements in the market so far it looks like a day where mortgage REITs with higher duration (often caused by smaller hedges) should perform better. The mREITs with less credit exposure should also be expected to perform better, though I think non-agency RMBS remain a fairly reasonable investment area.
I'm concerned that the market has valued mortgage REITs so highly, relative to a quarter ago. The flattening of the yield curve and the rising level of prepayments creates a real problem for the sector. On the other hand the spread between expected yields on agency MBS and the cost of hedging through LIBOR swaps is fairly large and that counteracts some of the challenge from a flatter yield curve.
If you want something really funny, New York Mortgage Trust (NASDAQ:NYMT) is only down .8% on the day. Their portfolio heavily emphasizes the most credit sensitive assets and "Interest Only Strips". Both assets should have been thoroughly slammed today. The credit sensitive assets should be up heavily on the quarter, but for the day it should be pretty ugly.
The selling activity in the market today primarily reflects fear. While I like buying on fear, I don't like most of the valuations across the sector. The ideal entry time is when valuations were already attractive and fear levels climb to the point that panic wins out and share prices go on hard sales. I would want to see Annaly Capital Management sliding under $10 before I could feel that enough fear was built into the prices to provide a very compelling investment opportunity.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PREFERRED SHARES OF AGNC over the next 72 hours.
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