Imagined improvements
Bloomberg reported Ben Bernanke as saying that the asset purchases are by no means on a preset course. In simple words, he linked a halt in asset purchases to improvements in the economic and financial conditions of the country. Besides inflation, the central bank is particularly monitoring the U.S. labor and housing markets for signs of improvements. The asset purchases could even be prolonged until the ‘imagined improvements’ are not seen.
Priced in
Speculations and confusion surround the unwinding of asset purchases has hurt mortgage REITs the most. The markets started pricing in the effect of the Fed’s exit since the first quarter, and as a result, we saw a rise in interest rates.
The yield on 10-year Treasury was 1.75% on the day when Fed announced the launch of QE3, compared to 2.57% now, while the 30-year fixed mortgage rate was at 4.09%, compared to 4.51% now. It shows that rates have risen over pre-QE3 levels, meaning much of the QE3 unwinding effect is already priced in.
Skydive
I believe mortgage REITs have suffered the most, given this rise in interest rates amid speculations about the Fed’s exit. Mortgage REIT EFT (MORT) has plunged 17% over the past three months, while mortgage REITs like American Capital Agency Corp. (NASDAQ:AGNC), Annaly Capital Management, Inc. (NYSE:NLY) and ARMOUR Residential REIT, Inc. (NYSE:ARR) have experienced declines of 23%, 13%, and 30%, respectively, since the beginning of the year.
Mortgage REITs saw these declines as prices of their fixed income portfolios are inversely proportional to changes in interest rates, causing mortgage REITs’ book value to plunge when the rates increase. Since their MBS holdings are the only assets, the stock price follows the plunge in the book values.
Oversold and undervalued
The declines in the stock prices of the aforementioned mREITs lead me to believe that they have been oversold and undervalued. Looking at the price-to-book value multiples, I see American Capital Agency Corp. (NASDAQ:AGNC) trading at 23% discount to its first quarter book value. Similarly, Annaly Capital Management, Inc. (NYSE:NLY) and ARMOUR Residential REIT, Inc. (NYSE:ARR) are trading at 21% and 39% discounts, respectively.
Since the second quarter is already over and the book values are expected to fall, the use of first quarter book value does not seem an ideal parameter to determine valuations. So, I used the estimated second quarter-end book values provided by Barclays PLC (ADR) (NYSE:BCS).
Using the estimated figures provided by analysts at Barclays PLC (ADR) (NYSE:BCS), I see American Capital Agency Corp. (NASDAQ:AGNC) trading at 12% discount, while Annaly Capital Management, Inc. (NYSE:NLY) and ARMOUR Residential REIT, Inc. (NYSE:ARR) are trading at 10.7% and 21%, respectively. These significant discounts lead me to believe that these stocks are attractively valued right now.
For a stock to be attractively valued, it has to be both undervalued and estimated to increase in price due to either company specific or macro factors. While we have noticed that the stocks are undervalued, let’s see why I believe they will increase in price in the coming future, which makes them attractively valued.
Long-term perspective
I am sure you must have come across a lot of negative sentiment about the outlook of the mortgage REITs sector, but these sentiments ignore the longer-term outlook. We have already established that one effect of rising rates is the decline in the book values. However, what investors fail to understand is that there is another effect which tends to increase the spread for mortgage REITs.
Both these effects come into play at different times. The decline in book values is the short-term effect, while in the longer-term, mortgage REITs are expected to report expansion in their net interest spreads as they continue to deploy more capital to acquire new production MBS.
So, a combination of a positive outlook and the current cheap valuations make American Capital Agency Corp. (NASDAQ:AGNC), Annaly Capital Management, Inc. (NYSE:NLY), and ARMOUR Residential REIT, Inc. (NYSE:ARR) attractively valued. Now, let’s look at what’s going on at these companies.
The largest mREIT
Annaly Capital Management, Inc. (NYSE:NLY) is the largest mREIT in the U.S. with a variety of bullish factors. The company externalized its management structure, just like American Capital. This has resulted in reduced compensation costs for Annaly Capital Management, Inc. (NYSE:NLY), which will provide some support to the bottom line.
Besides, it has some commercial real estate loans (CRE) in its portfolio. These provide higher returns and cushion book value against further erosion. The company also employs relatively less debt, which will provide another cushion against fluctuations in results.
Re-balancing exercise
American Capital Agency Corp. (NASDAQ:AGNC) is one of the most well-managed mREITs. It recently conducted a re-balancing exercise under which it got rid of some of the longer duration (30-year) fixed rate security. This security is considered most sensitive to changes in interest rates, largely due to a higher duration. These efforts would result in protecting the company’s book value, while active management of assets and hedges will create higher returns.
Hammered the most
Among the Agency-only players, ARMOUR Residential REIT, Inc. (NYSE:ARR) has been hammered the most since the beginning of the current year. ARMOUR’s investors could see a better future for their company if it sells its assets to reduce leverage and add additional swaps.
Conclusion
While American Capital Agency Corp. (NASDAQ:AGNC), Annaly Capital Management, and ARMOUR Residential REIT, Inc. (NYSE:ARR) are facing tremendous pressure on their book values, I believe this is short-term. For a long-term investor, this is an ideal entry point as the stocks are both undervalued and are positioned to appreciate over the coming quarters.
The article Mortgage REITs: A Long-Term Bet originally appeared on Fool.com and is written by Adnan Khan.
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.
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