The latest weekly Mortgage Bankers Association survey is out with some sigh of relief for the pure-play mREITs. The survey reveals a hike in mortgage rates, supported by a decline in the refinance index. Therefore, you can expect the pure-play mortgage REITs, like American Capital Agency Corp. (NASDAQ:AGNC), Annaly Capital Management, Inc. (NYSE:NLY), and Two Harbors Investment Corp (NYSE:TWO) to fly high as the trend continues. I recommend investors consider them as an investment opportunity before they appreciate in value.
A haunting past
Mortgage REITs, including American Capital Agency Corp. (NASDAQ:AGNC), Annaly Capital Management, Inc. (NYSE:NLY), and Two Harbors Investment Corp (NYSE:TWO), took a lot of damage at the hands of the Fed and its easing programs. Even during the first quarter of the current year, American Capital Agency Corp. (NASDAQ:AGNC) and Annaly Capital Management, Inc. (NYSE:NLY) reported a 2 bps and 3 bps declines in their average asset yields, respectively. Two Harbors Investment Corp (NYSE:TWO) reported a flat asset yield during the first quarter compared to the prior quarter.
As a result, American Capital Agency Corp. (NASDAQ:AGNC) reported an 11 bps sequential contraction in its spread, while Annaly Capital reported 4 bps compression in its spread. Two Harbors reported a flat spread of 2.9% over the prior quarter.
While Annaly Capital Management, Inc. (NYSE:NLY) was forced to cut its dividend twice during the prior year, Two Harbors slashed its dividend once. In contrast, American Capital Agency maintained its quarterly shareholder distribution of $1.25 per share.
A bright future
According to the latest weekly mortgage market survey conducted by the Mortgage Bankers Association, the situation has become more favorable for the pure-play mREITs as the Refinance Index plunges along with the climb in long-term mortgage rates.
The survey reveals the mortgage rates increased to their highest since March. The average 30-year fixed mortgage rate on conforming loan balances increased 11 bps, while the 30-year fixed mortgage rate with jumbo balances increased 6 bps. At the same time, the 15-year fixed rate mortgage increased 8 bps. The hike in mortgage rates has a two-fold effect on mortgage REITs. First, the interest earned on the MSB is directly linked to the mortgage rates. Second, higher mortgage rates discourage refinancing.
A decline in refinancing activity was also reported in the latest weekly survey. The Refinance Index, which is the best overall gauge of mortgage refinance activity, fell 12% over the prior week. It has fallen 19% over the past two weeks to lowest since late March. This is particularly beneficial for mREITs as refinance tends to increase their prepayments causing higher amortization costs. This ultimately hurts profitability.
However, on the downside, mortgage applications also declined around 10% compared to the prior week. This is the second consecutive week that the survey reported a decline in mortgage applications. Fewer mortgage applications mean less home loans to be bundled to make mortgage backed securities. This means, less supply of MBS, which should increase the price and decrease the yield on them. Therefore, the decline in the mortgage applications would mean low asset yields in the coming quarters.
Sustainable future dividends and anticipated higher income
You can expect Annaly Capital Management, Inc. (NYSE:NLY) to report 17% higher net interest income if the rates climb 50 bps. Therefore, the least you can expect is Annaly to maintain its dividends. Since Annaly Capital Management, Inc. (NYSE:NLY) has a cash dividend coverage ratio of 1 times, it needed the widening of mortgage spreads. Therefore, if the Fed decides to cool down its MBS purchases, you can expect Annaly to report higher income.
Re-positioning will work out
While I believe American Capital Agency Corp. (NASDAQ:AGNC)’s current investments will face headwinds in an increasing interest rate environment, its management has made efforts to re-position its investment portfolio after the first-quarter results, which took a chunk away from its book value. After the re-positioning, you can expect the company to perform better during an increasing interest rate environment, which is highly likely in the coming future. American Capital Agency Corp. (NASDAQ:AGNC) has a current cash dividend coverage ratio of 1.2 times. I feel the re-positioning will further boost the company’s dividend paying ability.
Stable returns due to a diverse asset base
Two Harbors Investment Corp (NYSE:TWO) is know to posses a well known asset portfolio. Besides owing MBS that generate interest income, the company has investments in real estate facilities that generate rental income. Therefore, during a declining interest rate environment, the company can rely on its rental income to provide stable returns. Besides, you can expect the company to report around 6.6% higher interest income if the rates climb 50 bps. This is because its MBS holdings are positioned to benefit from a hike in the general interest rate environment.
Foolish takeaway
The rising mortgage rates, combined with a decline in the refinance activity as reported by the Mortgage Bankers Association, is a sign of relief for the mREITs sector, particularly the aforementioned three companies. Therefore, investors looking to increase their regular income should consider this trend as an investment opportunity in the aforementioned stocks.
The article Forget the Ugly Past and Look at the Bright Future of These Stocks 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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