Stocks snapped a losing streak late last week with a big rally after the release of a series of positive data, including encouraging jobless claims and upbeat retail sales. The data also overshadowed fears about growth in Japan. The mortgage REITs sector also rallied as measured by a 4.8% rally in the sector’s ETF. However, the mREITs sector had its own reasons for the rally.
Annaly Capital Management, Inc. (NYSE:NLY) and
mREITs rally
The mREITs sector took a breath of relief after the release of some encouraging labor market data and the upbeat retail sales figures. While the data swept away concerns about Japan, the mortgage REITs had their own reasons for the rally.
I believe it was largely the announcement made by the two sister mREITs, ARMOUR Residential REIT, Inc. (NYSE:ARR) and Javelin Mortgage Investment Corp (NYSE:JMI). In contrast to popular opinion, both mREITs maintained their monthly dividend rates. This is considerable positive news, particularly amid rising interest rates that are eroding their book values.
Bloomberg reported both ARMOUR Residential REIT, Inc. (NYSE:ARR) and Javelin Mortgage Investment Corp (NYSE:JMI) as the worst, and the second worst performing mREITs around the unwinding of the QE, while in my previous article, I was also of the view that both these mREITs will face pressure on their book values and also on the spreads, which is why dividend cuts can’t be ruled out. However, they proved otherwise.
If you look at the sustainability of dividends from another angle, it could mean fewer compression in the companies’ net interest rate spreads.
Significance of recent encouraging data
While the release of the recent data related to retail sales and the U.S. labor markets is encouraging for the general economy, it is not for the mREITs sector. Encouraging numbers mean may lead to stability and growth in the economy, but for the mREITs, it means an early Fed’s exit from the Agency MBS markets.
Although much of the effects of the Fed’s exit have already been priced in and the interest rates have started increasing, the exit itself will further increase volatility. While higher mortgage rates and the resultant higher Agency MBS spreads might mean higher spreads for mortgage REITs in the longer-term, in the short-term, the book values of ARMOUR Residential REIT, Inc. (NYSE:ARR) and Javelin Mortgage Investment Corp (NYSE:JMI) will fall significantly. According to Reuters, JAVELIN has an 8 times debt to equity ratio, while ARMOUR Residential REIT, Inc. (NYSE:ARR) reported 9.2 times debt. Both are considered to be highly leveraged, which is why the results of the book value erosion will be magnified.
We saw a glimpse of this during the first quarter when ARMOUR reported 8.2% decline in its book value coupled with a 20 bps contraction in the spread. Javelin Mortgage Investment Corp (NYSE:JMI) does not have much of a history to compare it with. However, from the fourth quarter, it reported a 7% decline in its book value while the spread came down 40 bps.
Approach for the future
For both JAVELIN and ARMOUR, the future lies in the re-balancing and active management of the companies’ assets. While JAVELIN is already a hybrid mREIT, ARMOUR Residential REIT, Inc. (NYSE:ARR)’s charter permits the company to include securities other than Agency residential MBS. However, the company is only invested in Agency residential MBS till now. Diversification into the non-Agency space, getting rid of some of 30-year fixed rate Agency paper, and active management of assets to capture attractive opportunities as and when they come is the only way out for ARMOUR Residential.
For Javelin Mortgage Investment Corp (NYSE:JMI), a portfolio tilt towards the high yielding non-Agency MBS including commercial MBS will create value. The company is currently largely invested in Agency RMBS (90% of the portfolio), while the rest are non-Agency securities. I believe an increase in the non-Agency’s proportion would support the company’s net interest rate spread, while also providing protection to book value erosion. Further, reduction in the amounts of leverage that both companies have employed should reduce volatility in the coming quarter’s financial results.
Competition
Both JAVELIN and ARMOUR compete with Annaly Capital Management, Inc. (NYSE:NLY) and American Capital Agency Corp. (NASDAQ:AGNC) to purchase the Agency paper. Both American Capital Agency Corp. (NASDAQ:AGNC) and Annaly Capital Management, Inc. (NYSE:NLY) are well managed, large Agency mortgage REITs.
American Capital Agency Corp. (NASDAQ:AGNC) recently announced its future approach of reducing some of the 30-year fixed rate Agency paper from its portfolio, while also renewing its resolve to manage its hedges and assets actively to produce attractive opportunities. This much awaited move would lead the company to provide some support to its book value and the net interest rate spread. Without this move, analysts at Credit Suisse were expecting a 20% decline its dividends.
Annaly Capital Management, Inc. (NYSE:NLY) was already prepared for the rising interest rates environment. The challenges in the third and fourth quarters last year led the company towards a diversification attempt. Annaly Capital Management, Inc. (NYSE:NLY) purchased CreXus Investments, a REIT that invests in commercial MBS. This is now providing the company with the much required low double-digit returns, while it’s also saving on compensation expense due to the externalization of its management. So, its fair to say that Annaly Capital Management, Inc. (NYSE:NLY)’s returns are safe. To secure its book value, the company has CRE loans and a relatively less leverage (6.7 times). These will provide some cushion to the book value erosion.
Conclusion
JAVELIN and ARMOUR’s announcements about maintaining their dividend rates for the third quarter led the recent rally in the mREITs sector. However, both need to take some corrective actions in order to perform better under the given volatile market conditions.
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 Mortgage REITs Rallied, But Why? originally appeared on Fool.com is written by Adnan Khan.
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