Rising interest rates cause the value of fixed-income instruments to fall. Nearly all of the assets held by mortgage REITs are mortgage-backed securities (MBS) which are primarily fixed-income instruments. Since the start of speculation surrounding the quantitative easing unwinding, mortgage REITs have been in the news due to the fear of significant declines in their book values. While book value declines will remain a major reasons for concern, I have reasons to believe this will not be the case for American Capital Mortgage Investment Crp (NASDAQ:MTGE).
Improved duration gap and interest rate sensitivity
Going forward, I believe that the company will once again report lower book value declines than its peers. That’s because during the second quarter, American Capital Mortgage Investment Crp (NASDAQ:MTGE) improved its net duration gap from 0.1 years to 0.2 years while also improving its interest rate sensitivity.
The book value will decline 1% and 2.5%, if rates go up 50 and 100 basis points, respectively. This is compared to the prior quarter’s 3.3% and 9.2% declines in book value if the rates went up 50 and 100 basis points. As you can see, this is a significant improvement. These improvements were a result of reducing the TBA exposure (from 38% of the entire portfolio in the first quarter to 1% in the second quarter) and tilting the portfolio towards the non-Agency MBS. Non-Agency securities were 20% of the entire portfolio at the end of the first quarter. Now, they are 28% of the portfolio.
Peer analysis
Let’s look at a couple of American Capital Mortgage Investment Crp (NASDAQ:MTGE)’s peers and how their book values held up during the second quarter.
The charter of Anworth Mortgage Asset Corporation (NYSE:ANH) allows it to include hybrid securities including Agency and non-Agency MBS in its portfolio. The management chooses to add only securities with fixed and adjustable rates for which the US government guarantees principal and interest payments, however.
At the end of the second quarter, Anworth Mortgage Asset Corporation (NYSE:ANH) reported core earnings per share of $0.13, in line with the consensus estimate. However, the reported book value erosion of 15% was not in line with the expectations of analysts at Credit Suisse. Credit Suisse analysts were expecting a 17% decline in the book value. Anworth’s book value decline is also better than the massive 20% decline that Hatteras Financial has reported, but is still higher than the book value decline reported by American Capital Mortgage Investment Crp (NASDAQ:MTGE). The reason is the difference between the natures of their portfolios. Both Hatteras and Anworth said that wider spreads on their hybrid adjustable-rate securities were the biggest reason for the book value decline. On the positive side, Anworth reported 11 basis points expansion in its net interest rate spread, due to abundance hybrid adjustable-rate securities.
ARMOUR Residential REIT, Inc. (NYSE:ARR) is another mREIT that invests exclusively in Agency fixed-rate residential mortgage backed securities. The company reported worse-than-expected book value at the end of the second quarter. Its book value plunged 19% during the second quarter, which was 8% more than forecasted by Credit Suisse analysts. Much of the decline in the book value was associated to lower-than-expected swap gains. Also, during the quarter, ARMOUR reduced the size of its assets portfolio by 7%. However, the relative proportions of fixed-rate to adjustable-rate mortgage remained the same at 94% to 6%, respectively. The company benefitted from lower prepayments, which resulted in higher asset yields and the resultant 4 basis points higher spread.
Compared to the prior quarter, the interest rate sensitivity of ARMOUR Residential REIT, Inc. (NYSE:ARR)’s book value has decreased. Now, the company’s book value will plunge 2.56% and 1.26% if rates go up 100 and 50 basis points. This is compared to 2.42% and 1.27% declines at the end of the first quarter if the rates went up 100 and 50 basis points, respectively.
Conclusion
Given continued uncertainty surrounding the unwinding of quantitative easing, I believe American Capital Mortgage is one of the mortgage REITs that will report least book value decline during the third quarter. The managements’ strategy has made it possible during the second quarter, and the reduced interest rate sensitively will make it possible the next time as well. Because of this, I am bullish on the stock.
Adnan Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
The article Expect the Smallest Book Value Decline from This mREIT 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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