It has been well documented that the Fed’s newest asset purchase program has depressed the yields on MBS, squeezing income for highly leveraged mREITs that rely on the interest spread between the interest they are paying on their borrowed money and interest received from MBS to generate income for shareholders.
However, with rumors about the Fed’s tapering of asset purchases starting to circulate, could now be the time to buy into mREITs before the Fed starts selling its assets and yields start rising?
What is the Fed going to do?
Recent minutes of the Federal Open Market Committee meetings revealed that some members of the committee are worried about potential losses on the Fed’s massive holdings of MBS. To stem such losses, the committee might have to taper asset purchases early before a serious improvement in the labor market.
The Fed currently holds $1.1 trillion in mortgage-backed securities, and with a continuation of buying at a rate of $85 billion a month, the bank is inline to increase its holdings to $1.5 trillion by year end. This astronomic figure is about 27% of the MBS market.
Now, here is the problem: any entity that holds such a large portion of the market is bound to significantly affect the whole market when it comes to the point of selling. The Fed in particular will have to sell $1.5 trillion in MBS into a shallow market, which will cause prices to fall. Falling prices will mean higher yields, and the Fed will have to wind down its huge portfolio into a seller’s market.
This is what the Fed is worried about – huge losses on its assets that it will be forced to take by selling at non-beneficial prices. The Fed could use an interest rate swap to hedge its assets, but as of yet this has not been initiated.
When the Fed begins selling, yields of mortgage-backed securities will rise and mREITs will gain from a higher income on their assets again.
So, could it be time to buy?
I am not a fan of leverage, especially with mREITs in particular; however, there are a few that look to be in a solid financial position with a good history of returns.
Still, the company has achieved a total return of around 600% since inceptio,n and although returns are currently slipping, an end to the Fed’s asset buying would definitely drive returns higher once again.
On the other hand, Two Harbors Investment Corp (NYSE:TWO) offers investors exposure to the riskier but more lucrative sub-prime market. The company owns a mixture of both agency and lower-credit-quality debt, which produces a higher return for shareholders In particular, while Two’s peers, which mainly invest in agency debt only, have seen their interest rate spreads decline from about 2% on average, down to slightly above 1%, Two’s spread has remained high, starting at slightly above 3.6% and falling to just under 3%.
Two Harbor’s should see the most improvement in its income if the Fed stops asset purchases as the company’s low-credit-level debt would fall in price and drive the already high yield higher!
American Capital Agency Corp. (NASDAQ:AGNC) also offers investors exposure to high yield, non-agency mortgage backed securities. However, the company’s portfolio of these investments is much smaller than that of Two Harbors Investment Corp (NYSE:TWO).
American Capital Agency Corp. (NASDAQ:AGNC) has 6% of its portfolio in non-agency investments, and 15% of this is sub-prime assets – reducing risk but also reducing returns
American Capital Agency Corp. (NASDAQ:AGNC) currently offers a huge 15% yield, which does make me cautious. That said, the company has been increasing its assets under management and decreasing its leverage during the past year, which has increased income and shareholder equity at the same time.
