Misery Loves Mortgage REITs

If there’s no such thing as a safe double-digit yield in this era of ultra-low interest rates, what’s there to say about a security with a projected dividend return of 18 percent over the next year?

One inference might be that one is likelier to experience Rapture than to get fully paid; another that the stock is priced for Armageddon.

Which way one leans in regards to American Capital Agency (Nasdaq: AGNC) and other mortgage REITS really is a matter of theology. Faith that a powerful and merciful Federal Reserve will keep interest rates low for a long time to come would suggest that AGNC and its peers, like the government-backed mortgage securities (MBS) they hold, have been unjustly crucified. Lately, though, markets have lost some certainty in friendly intervention from on high and punished greed for high recurring income rather biblically.

AGNC and its brethren buy the right to income from bundles of mortgages, the repayment of which is guaranteed by the federal government through agencies like Freddie Mac, Fannie Mae and Ginnie Mae.

The mortgage REITs’ investment funds are mostly borrowed in the short-term repo market, and the modest yield spread they earn is amplified by leverage, so that AGNC, for example, recently held assets amounting to eight times its capital.

That’s a great business model so long as rates make no abrupt moves and the repo lenders don’t get cold feet. But rates have moved up fairly dramatically of late in anticipation that the Fed may, as soon as this year, start to curtail its latest bond-buying program, which monthly purchases $40 billion of agency MBS along with $45 billion of Treasuries.

Since the beginning of May, the 10-year Treasury yield has moved up from 1.63 percent to 2.51 percent. Given the leverage, and despite the hedging used to limit interest rate losses, the book value of AGNC and other mortgage REITS has taken a hit. For AGNC, book value fell 8.6 percent, or $2.71 per share for the quarter ended March 31, By June 7, widening MBS spreads relative to Treasuries had sapped book value as much again, and it seems reasonable to assume that the spread increases since have inflicted yet another, comparable hit to AGNC’s portfolio, so that at this point book value might be $24 or so.

Of course, the stock  is down to $23 after a 30 percent pounding since May 2, and so likely continues to trade at a discount to book value, whereas in happier times it has fetched a slight premium.

One reason AGNC has been punished more than peers is that it employs somewhat higher leverage than big competitor Annaly Capital (NYSE: NLY), which was recently at 6.6 times. AGNC also invests overwhelmingly in fixed-rate MBS unlike, say, Capstead Mortgage (NYSE: CMO), which sticks mostly to the adjustable-rate mortgages that protect it against rising rates. Moreover, AGNC has invested in securities hedged against the prepayment risk that goes with lower rates, and those premiums have taken an especially big hit now that higher rates have made prepayment less likely.

The irony is that when the Fed announced the latest bond-buying initiative last fall, mortgage REITs slumped because prospective increases in book value were overshadowed by margin compression worries. And now that spreads have blown out, boosting future margins, it is the book value fears that have come to the fore. Investors drawn by double-digit yields have too often of late found a half-empty glass instead.

That might change in the near future even if the economy continues to make fitful forward progress. Among those who see glass as half-full is celebrated bond manager Jeffrey Gundlach, who has argued this week that the selloff has created a juicy opportunity in agency MBS, and that investors are overestimating the odds that rates will keep on rising from here.

AGNC, too, still trusts in a helpful Fed, pointing out that the central bank will hold $1.5 trillion in agency mortgages by the end of the year, having bought up as much as 40 percent of the monthly issuance in the third quarter.  The REIT recently lowered its quarterly dividend from $1.20 to $1.05 a share, a level it will likely want to hold for the remainder of the year. If it does so, and if the spreads come in, the capital gain from current levels could rival that 18 percent yield.

On the other hand, should rates keep rising, repo lenders may start tightening the margin screws, further hurting profits. The leverage employed by mortgage REITs has also recently been cited as a systemic risk by regulators with the power to curb it.

These are big risks, but barring a regime change, mortgage REITs appear to have already paid a heavy  price for the damage higher rates have done to their portfolios. Whereas the future benefit of higher spreads may well have been discounted to this point.

In any case, it hardly requires a leap of faith to believe that the Fed will continue to support a sector so vital to the health of the economy.