Amid concerns regarding QE unwinding, agency mREITs have experienced their biggest slide since October 2011 reports Bloomberg. A lot has been said about the sustainability of the sector’s business model, and some have even marked the mREITs as a toxic investment. However, I am bullish on the sector and recommend long-term investors consider accumulating Agency mREITs on continued weakness. In particular, I favor the most well managed American Capital Agency Corp. (NASDAQ:AGNC), Annaly Capital Management, Inc. (NYSE:NLY) and Capstead Mortgage Corporation (NYSE:CMO).
The business model
Agency mREITs hold portfolios of residential mortgage backed securities that are issued and guaranteed by any of the government agencies including Freddie Mac and Fannie Mae. These asset portfolios are leveraged so that the returns can be magnified in order to provide elevated returns to shareholders.
The returns on residential Agency MBS are highly dependent on the prevailing interest rates, and so is the cost of funds. The difference between the asset return and cost of funds is known as the net interest rate spread.
Since the returns are leveraged, slight moves in the interest rates have a devastating impact on the book value, the net interest rate spread and finally the dividend rate. The accelerated prepayments over the last few quarters combined with the current rising rates environment have caused many investors to question the business model. However, I believe the business model concerns are invalid, and investors with a long-term perspective must take advantage of the current weakness and start accumulating the mREITs into their high dividend yielding portfolios.
Largest weakness since 2011
The interest rates have started climbing higher since the beginning of the year, owing to concerns regarding an early exit by the Fed from the Agency MBS markets. These higher rates have multiple effects on the mortgage REITs sector as noted above, but the most profound is the decline in the book values. It’s critically important for the mREITs because the mREITs trade in proximity to their book values. A decline in the book value means a decline in the stock price.
Mortgage REIT ETFs iShares FTSE NAREIT Mortgage REITs Index ETF (REM) and the Market Vectors Mortgage REIT Income ETF (MORT) fell 12% each since the start of the year, while Annaly Capital Management, Inc. (NYSE:NLY) and American Capital Agency Corp. (NASDAQ:AGNC) fell 18% and 29%, respectively. Capstead Mortgage Corporation (NYSE:CMO) was spared and only fell 0.5% since the beginning of the year.
The continued weakness in the sector is not the only bullish factor. The efforts made by some of the mREITs also make me bullish on these stocks.
The largest mREIT
Credit: Annaly Capital Management, Inc. (NYSE:NLY)
Some other steps that the management can take include getting rid of some of its exposure in the 30-year fixed rate Agency paper. This is considered most sensitive to moves in interest rates. Since Annaly Capital Management, Inc. (NYSE:NLY) is exclusively invested in fixed rate Agency MBS, the 30-year fixed security accounts for a large part of the entire portfolio.
More rebalancing could help
American Capital Agency Corp. (NASDAQ:AGNC) conducted a rebalancing exercise recently, which includes reducing exposure to the 30-year fixed rate Agency MBS and reassuring its resolve to actively manage its assets and hedges. While these efforts would bear positive results in terms of reducing book value volatility, I believe these will result in lower earnings potential.
So, further rebalancing could help American Capital Agency Corp. (NASDAQ:AGNC). The company is also currently exclusively invested in the fixed rate Agency MBS.
The addition of adjustable-rate Agency securities in the company’s portfolio could result in higher earnings and further decrease the book value volatility. Let me explain how.
Interest payments on the adjustable-rates securities adjust to the more current prevailing rates on the next reset date. So, the book value volatility, if any is experienced only between two reset dates. Further, since the interest payments adjust to more current rates, the company can gain an advantage from the current higher interest rates.
Adjustable-rate Agency-only
Capstead Mortgage Corporation (NYSE:CMO) is one such Agency-only mREIT that invests in adjustable-rate Agency paper only. According to the company financial disclosures, Capstead’s investment strategy is to mitigate the risk by focusing on investments that are considered to have little credit risk and are collateralized by adjustable-rate mortgage loans with interest rates that reset on the next reset date to more current levels. These characteristics led Capstead to report considerably less vulnerability to significant price declines caused by changes in interest rates.
That is exactly why it has not seen a significant decline in its stock price. The design and nature of the company’s investment portfolio led it to report a dividend for the second quarter, which was in line with the prior quarter’s distribution. In contrast, both American Capital Agency Corp. (NASDAQ:AGNC) and Annaly Capital Management, Inc. (NYSE:NLY) reported declines in their second quarter shareholder distributions.
Conclusion
While the mortgage REITs sector experiences considerable weakness due to the speculations about the Fed’s exit from the Agency MBS markets, I am bullish on the Agency mREITs. The aforementioned mREITs have made some rebalancing efforts, which make me more bullish on the stocks. I also believe that the proposed rebalancing efforts would result in further enhancing the returns.
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.
The article Further Rebalancing to Help These mREITs originally appeared on Fool.com and is written by Adnan Khan.
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