American Capital Agency Corp. (AGNC), Annaly Capital Management, Inc. (NLY): Bernanke’s Words Look Promising for mREITs

This sector is especially levered to quick jumps in rates because their portfolios are levered. If MBS prices drop 5%, for example, book value may fall by 30% or more due to leverage. We watched this happen in the most recent market rout, as book values tumbled across the board.

Secondly, mREITs generate gains or losses from interest spreads. If an mREIT borrows at 2% to buy a portfolio of mortgage-backed securities at a yield of 5%, it earns 3% per year on the investment. Levered at 8-to-1, it could earn 24% per year on its equity investment. This explains why mREIT dividend yields are so high.

The best case scenario is here

I previously wrote about the mREITs’ responsiveness to Bernanke’s tapering, noting that I did not expect a worst case scenario. A worst case scenario is one in which rates rise very quickly, MBS values plummet, and mREITs become insolvent as they owe more to creditors than their packaged mortgage securities are worth on the market.

Given Bernanke’s recent words about an eventual taper, it seems 30-year mortgage rates may teeter around 4.5% for quite some time while short-term rates remain stuck on their historical lows. Bernanke may not taper at all in 2013. Besides, tapering must come before a rise in short-term interest rates. The mREITs’ spreads are just fine.

Thus, I think now is the best time to own mREITs as they can deploy capital into new mortgage-backed securities at higher rates, earning a larger spread.

I’m going long American Capital Agency Corp. (NASDAQ:AGNC) here on CAPS. Ultimately, I believe the Fed’s taper is priced in, and upon the Fed’s exit, mortgage-backed securities will experience only minimal increases in rates. The market priced Bernanke’s next move in, and mREITs can tolerate very slow increases in 15- and 30-year mortgage rates.

The article Bernanke’s Words Look Promising for mREITs originally appeared on Fool.com and is written by Jordan Wathen.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Jordan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

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