The current market regime has created tremendous changes to the "risk and reward" environment in virtually all financial assets. There has been an immense increase in liquidity supply as investors have poured their remaining cash reserves into financial assets and as the Federal Reserve has left its liquidity floodgate wide open. Accordingly, valuations have risen to extremely high levels, and investors have searched for those few remaining discounted investments.
When investors look for discounts, they often search for those stocks and bonds with the highest yields. In general, higher-yielding assets do trade at lower fundamental valuations compared to others. That said, numerous high yield assets are "value traps" that appear to have low valuations but only because of immense risk. Truly, in the current aggressive investing environment, few industries with low valuations do not carry tremendous downside risk. However, that has not stopped investors from flocking to ultra high-yield investment options such as mortgage REITs.
Mortgage REITs are companies that borrow large sums to invest in mortgages - essentially a bank with the tax benefits of REITs. I have focused a large portion of my research on mortgage REITs over the past year for numerous reasons. Of course, mortgage REITs were the "hidden dynamite" that exploded many portfolios during the 2008 financial crisis and have a long history of implosion. Last spring, however, after each crisis, mortgage REITs have adopted increasingly complex hedging strategies as a means of shielding risks. The latest of which occurred as COVID fears sparked a wave of margin call sells in mortgage-backed securities.
In my opinion, the discussions regarding mREITs focus too much on yields and past performance and not enough on hedging strategies. Considering mREITs usually "rise like an escalator and fall like an elevator," hedging strategies are perhaps the most important aspect to consider when looking at mortgage REITs. Hedgeable risk factors include credit risk, interest rate risk, prepayment risk, and mortgage spread risk. Ideally, an mREIT that hedges all risk and still generates a consistently positive return would be a "free lunch" investment.
Of all the mREITs on the market, the largest player Annaly (NYSE:NLY), has perhaps the most advanced hedging strategy and an attractive 10.3% yield. That said, the company requires closer inspection since shifting market dynamics may upset its yield and net asset value. Let's take a closer look.
We must first discuss how mortgage REITs function before we dive deep into Annaly's risk and reward profile. Consider a "vanilla" mREIT that uses 6X leverage (roughly the same as Annaly's today), borrowing at 0.85% (near the discount rate), to invest all assets into a large pool of 30-year residential mortgages that have a 2.7% yield. Such an mREIT would generate a return on equity of 13.8%, which can be calculated as 2.7% (from equity) plus 11.1% (from six times the 1.85% difference between the mortgage yield and borrowing cost).
While such an mREIT has a very high return on equity, it also has numerous risk factors. With liabilities being 6X equity, it would only take a ~14% decline in asset value for the company to be bankrupt (where equity value equals zero as depressed asset value equals total liability level). An increase in mortgage defaults could cause such a decline (due to a home price decline or economic recession), a rise in mortgage rates (causing lower-rate mortgages to decline in value), or an increase in mortgage prepayment/refinancing rates.
In reality, most mortgage REITs focus most of their assets on agency mortgage-backed securities guaranteed by Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), so their credit risk is mitigated. In reality, agency MBS assets still carry some credit risk since 2008 proved that it is not guaranteed that these agencies can meet obligations if default rates climb too high.
Most mortgage REITs also easily hedge the bulk of their interest rate risks using interest rate swaps. Importantly, this strategy can only be used to hedge against increases in Treasury rates and not mortgages rates. The two normally move together, but economic fluctuations and actions from the Federal Reserve can alter the spread between guaranteed mortgages and Treasury bonds of an equivalent yield. This spread, known as the mortgage spread or "MBS spread," is usually between 50 bps and 2%. As you can see below, the Federal Reserve's MBS purchasing program has caused it to decline dramatically:
A rise in the mortgage spread is the chief risk of most mortgage REITs. It is what caused so many to crash last year as the spread rocketed up to 2%. However, it declined to nearly 50 bps after the Federal Reserve stepped in and purchased over a trillion in mortgage-backed securities. Importantly, the Federal Reserve's impact is fading as tapering nears as the mortgage spread has risen back to ~1%. This upward move coincides with Annaly's recent decline in value from $9.4 to $8.6 and may accelerate as the Fed's impact on mortgage rates ends.
As I've discussed in-depth regarding the mREIT (AGNC), a small move in this spread can cause a mREITs book value to decline by double digits. Higher mortgage rates do indeed decrease prepayment risks, slightly offsetting the downside risk from a higher mortgage spread. That said, the only true way to hedge against higher mortgage spreads is to invest in mortgage-servicing rights (MSRs), which increase in value with mortgage rates.
After suffering immense losses from the spike in mortgage spreads last year, Annaly has grown its MSR portfolio dramatically to reduce its exposure to this risk. According to Annaly's Q2 SEC report (pg. 78), a 25 bps increase in the mortgage spread should cause NLY's NAV to decline 9%. This rate is about the same as on June 30th, so NLY's NAV is likely still nearly $8.4. However, if the rate climbs up to 1.5%, its NAV should slide ~18% to around $6.9. I expect this to occur over the coming months as the mortgage spread returns to historically normal levels as the Federal Reserve's impact fades. Of course, if the Fed's tapering policy causes a shock in the mortgage market and spreads rise back to 2%, then NLY's NAV could slide further.
The most significant risk facing Annaly's net asset value is a spike in mortgage spreads. That said, this risk is lower than before 2020 since the company has dramatically grown its MSR portfolio. This risk is also much higher for other mortgage REITs like AGNC and Armour Residential (ARR), which do not use an MSR hedging strategy.
Overall, Annaly's balance sheet risks are heavily mitigated. Roughly 71% of assets are in agency mortgage-backed securities which have minimal credit risk. Treasury interest rate hedges back three-quarters of its assets, so a 75 bps spike in rates would only cause its NAV to decline ~4.5% (see Annaly's Q2 SEC report pg. 78). The company has some prepayment risk, but this is not large and is mitigated because mortgages are unlikely to fall further given Federal Reserve tapering and rising rates.
With this in mind, many investors may see Annaly as a low-risk high-dividend investment opportunity. Indeed, compared to the many other mortgage REITs I've researched, Annaly's management team seems to be the most openly aware of the economic risk factors it faces and has made effective efforts to mitigate the risks related to expected impending Fed tapering. However, there is really no such thing as a free lunch in financial markets and, if they are found, they rarely last. Problematically, it appears that Annaly's strategy has taken a toll on its earnings and has led to a long-term consistent decline in book value that has completely offset its dividends. See below:
The decline in Annaly's book value occurred during a period of a low and generally declining yield curve, which caused prepayments to rise and net-interest margins to contract. In the future, I expect to see a higher yield curve and lower prepayments which may eventually slow the bleeding but will still cause some negative pressures on its net-asset-value.
Annaly is dipping its toes into a new market opportunity for mREITs with its MSR business. Since Annaly is hedging mortgage-spread risk with MSR's but outsources the actual servicing of these mortgages, they can be costly, while the MSR's partially hedge Annaly's largest risk factor. The company's recent investor call indicated that it plans to continue expanding its MSR platform and eventually build its own servicing capabilities. Overall, I believe it does give it stronger longer-term positioning, but it does add complexity to an already complex investment strategy.
Annaly is among the most interesting mortgage REITs on the market. It operates healthier than most, with exposure to agency and non-agency mortgages and a wide hedge strategy. Annaly is most certainly not risk-free but has a more diverse risk profile than most other mortgage REITs. In my experience, most mREITs usually have one "Achilles heel" that could bring bankruptcy. Conversely, Annaly's value will decline if there is a credit event, mortgage rate shock, or a rise in prepayments, but there would need to be an immense shock to impair Annaly's value permanently.
While Annaly may be better than most mortgage REITs, I would not personally buy the stock. Its risk mitigation strategy is strong, but with sky-high real estate prices and impending tapering from the Federal Reserve, I believe we may soon see a larger negative credit event in the mortgage market. Annaly can weather such a storm better than most, but the stock does not trade at a discount to its book value and does not generate consistently positive EPS, so its upside potential is minimal while its downside risk is material. Overall, I am slightly bearish on Annaly today but believe it may be among the best to buy as a "recovery trade" after the impacts of Fed tapering play out.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.