Mortgage REITs have remained a favorite investment vehicle for many investors’ for a very long time due to their elevated (double digit) dividend yields. Some of the most-followed REITs offer dividend yields in excess of 17%, while 10-year Treasuries are only offering 1.92%. However, these elevated dividend returns are not without elevated risk.
mREITs have a complex business model. It is a model in which the management does not have complete control over the company’s revenues. This is because its revenues are highly linked to the country’s macroeconomic environment, particularly the housing and mortgage markets.
The bond buying and its endeavors?
One of the major catalysts that are currently in play for mREITs is the Fed’s accelerated bond buying. The Fed has initiated an accelerated bond buying with an intention to stimulate the sluggish US economy, particularly the US housing and the labor markets. While the stimulus efforts are still delivering their results, profits at mortgage REITs are being crushed because of it.
The Fed is buying $40 worth of residential mortgage backed securities every month. These are the RMBS for which any of the government Agencies has guaranteed the principal and interest payments. The aim of this bond buying was to bring down the long-term mortgage rates in order to encourage refinancing and mortgage originations. However, one downside of this bond buying program is that lower long-term mortgage rates mean lower revenues for the Agency mortgage REITs.
How mREITs earn money?
Mortgage REITs own and invest in mortgage backed securities and earn an asset yield that is directly linked to the prevailing mortgage rates. Mortgage REITs finance their MBS portfolios using short-term repurchase agreements and pay a cost of fund on them. Finally, mortgage REITs earn a “spread” over what they pay on their interest bearing liabilities and what they earn on their interest yielding assets.
Little control over profits
However, prices of some of the most-followed mREITs bounced back yesterday after a string of weak economic data. The weak economic data led to a big drop in the Treasury yields yesterday as the 10-year Treasury fell 6 bps to 1.88%. As a result, Annaly Capital Management, Inc. (NYSE:NLY) and ARMOUR Residential REIT, Inc. (NYSE:ARR) experienced 1.9% and 2.6% increases in their respective stock prices, while Western Asset Mortgage led the recent rally as its shares surged 3.3%.
This makes in abundantly clear that management has little control over the profits and the stock price. Therefore, investors looking to invest should look for the following positive business drivers.
Annaly Capital Management, Inc. (NYSE:NLY)
Annaly Capital Management, Inc. (NYSE:NLY) happens to be the largest mortgage REIT in the US. The company has seen little appreciation in its stock price since the beginning of the year as its YTD is 5.8%. However, the stock price fell 7% since the start of the second quarter.
I believe decreased funding costs along with the MBS sold during the first quarter will allow Annaly Capital Management, Inc. (NYSE:NLY) to report higher spreads compared to the first quarter. Besides, the recent acquisition of CreXus Investments will increase Annaly’s average yield in the coming quarter. You can also expect a book value growth if prepayments remain moderate.
American Capital Agency Corp. (NASDAQ:AGNC)
American Capital Agency Corp. (NASDAQ:AGNC) has seen around 10% depreciation in its share price since the beginning of the second quarter. However, since the beginning of the year, shares increased 2% in value. The company is one of the most favored among analysts and investors due to its superior security selection ability. However, the company’s first quarter performance remained disappointing as the market started to price in a Fed exit from the MBS market. Since American Capital Agency Corp. (NASDAQ:AGNC) has a high allocation towards MBS with prepayment protected mortgages, they underperformed generic collateral and pushed the book value down.
However, much of the first quarter decline in book value has been reversed so far in the second quarter. I believe the post earnings sell-off and the recent dips present an excellent entry point. I am expecting a further rally in specified pools that pushes the book value about 10% higher to around $36.
ARMOUR Residential REIT, Inc. (NYSE:ARR)
ARMOUR Residential REIT, Inc. (NYSE:ARR) is another pure-play mortgage REIT. Its stock price has seen over 7.5% depreciation since the beginning of the year, while it fell 8.4% during the second quarter so far. The company’s first quarter results remained behind expectations. The relatively poor performance was a result of lower asset yields and higher cost of funds.
The company offers a dividend yield of just over 14%. However, I don’t see any positive drivers for ARMOUR Residential REIT, Inc. (NYSE:ARR) coming into play. Therefore, if you are considering ownership in ARMOUR, keep a close eye on the Fed’s stimulus programs.
Foolish Takeaways
Mortgage REITs are involved in a complex business model with high risks. However, they hold a special place in the hearts of investor, particularly the ones who want to expand their regular income. Therefore, keep a close eye on the developments at the Fed and the pace of the ongoing stimulus programs. In the prevailing environment, I see positive drivers for both American Capital Agency Corp. (NASDAQ:AGNC) and Annaly Capital Management.
The article Two mREITs To Buy, One To Avoid originally appeared on Fool.com and is written by Adnan Khan.
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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