The already pressured Agency mortgage REITs sector came under more pressure after the Financial Times reported that QE3 tapering is likely to be signaled by the Fed. The release of recent encouraging macroeconomic data related to US labor markets and retail sales has created speculation over whether the Fed might take it as a signal of an improving economy. However, the markets seem to be reluctant to acknowledge any improvement in the macroeconomic conditions that would lead the Fed towards the unwinding of QE. This unwinding would have a significant negative impact on the mREITs. Let’s see which mREITs will outperform.
The agency mREITs business model
Agency mREITs invest in the long-term mortgage backed securities for which the government guarantees the principal and interest payments. They earn a yield on these MBS, which are purchased using short-term financing. Finally, they earn a spread between the yield and the cost. So, the earnings of mREITs are highly dependent on changes in interest rates.
QE unwinding & its impact on mREITs
The Financial Times believes that the Fed might signal that it’s close to the tapering of QE3. The job market has shown some improvement since the start of QE3 last September. Expected unemployment has gone down from 7.75% to 7.4%, while average payroll growth in the past six months surged to 194,000 from 130,000 six months ago. Therefore, I believe the tapering of QE3 is coming soon.
Once the Fed exits the Agency MBS markets, the volatility in mortgage and interest rates will increase, while interest rates will increase further. The first quarter gave us a glimpse of this when speculations about the Fed’s exit started. This caused the mREITs to disclose significant book value erosion. ARMOUR Residential REIT, Inc. (NYSE:ARR) reported an 8.2% decline in its book value, while American Capital Agency Corp. (NASDAQ:AGNC) and Annaly Capital Management, Inc. (NYSE:NLY) reported 9% and 4% respective declines in their book values. So, preserving the book value is the most important task for mREITs right now.
Which mREITs to invest in?
So, the question is which mREITs to invest in amid the anticipated unwinding of QE3?
Among the pure-play mREITs, Annaly Capital Management, Inc. (NYSE:NLY) is best positioned to handle higher interest rates and expand its bottom line. It has already purchased CreXus Investments to tap into the commercial MBS market and the low double-digit returns available in that market. Besides, the company has already positioned its portfolio to better suit the climbing interest rate environment. In order to reduce its expenses, the company changed its management structure from an internally managed company to an externally managed company, leaving Annaly Capital Management, Inc. (NYSE:NLY) with lower compensation expense. Further, the lower level of leverage and presence of commercial real estate loans make Annaly Capital Management, Inc. (NYSE:NLY)’s book value and the bottom-line more insensitive to changes in interest rates.
American Capital Agency Corp. (NASDAQ:AGNC) was not well prepared for a QE tapering. Therefore, it suffered in terms of stock price depreciation in recent times. However, the management has announced that it has rebalanced its investment portfolio to better suit climbing interest rates. It has gotten rid of some of the long-term 30-year fixed residential MBS securities, which are considered highly sensitive to changes in interest rates. Further, it announced active management of its assets and hedges to create attractive investment opportunities. These efforts make the company more suitable for the current environment.
Two Harbors Investment Corp (NYSE:TWO) is another favored mREIT. It’s a hybrid mREIT that invests in both Agency and non-Agency MBS. It’s also among the top picks of Credit Suisse and Barclays. Two Harbors Investment Corp (NYSE:TWO) has significant exposure in the non-Agency space, which will enable to the company to withstand rising interest rates. The company also has a higher allocation to credit sensitive assets, which protects its book value. The company is taking advantage of its hybrid structure to pursue opportunities that differentiate it from its peers. These include its mortgage servicing (MSR) license. MSRs provide the company with an effective hedge and a source of higher income. MSRs increase in value as rates go up.
Conclusion
While the macroeconomic environment may become even more challenging if the Fed decides to exit the Agency MBS market, some mREITs have positioned their portfolios to take advantage of the situation. Annaly Capital Management, Inc. (NYSE:NLY), American Capital Agency Corp. (NASDAQ:AGNC) and Two Harbors are three such mREITs. Therefore, I am bullish on these stocks.
The article Buy These mREITs Amid QE Unwinding originally appeared on Fool.com.
Adnan Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Adnan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.
