As a result of recent volatility and spreads widening, mortgage REITs are in for a second consecutive quarter bloodbath as far as their book values are concerned. Although the stocks seem to have already priced this in, further decline in the book values cannot be ruled out. There is an upside for the book values if interest rates fall in the near term. However, that’s highly unlikely. Given the highly unlikely fall in rates, Barclays is bearish on American Capital Agency Corp. (NASDAQ:AGNC). Let’s see why.
Why rates will increase further
Regardless of the timings of the Fed’s exit, I believe interest rates will increase further. Yield on the 10-year treasury is still well below the historical norms, so rates have more room to rise than fall.
This further increase will hurt the mortgage REIT sector by creating more downward pressure on book values. When rates rise, MBS durations extend, which results in book value erosion if not adequately hedged with negative duration. This hedging also comes at a cost that lowers earnings.
Therefore, caution must be exercised when making an investment in mortgage REITs.
Why book values are critical
Now, you might be wondering if higher interest rates mean wider spreads for mortgage REITs and improved dividend prospects. So, why bother so much about the book values? That’s because mortgage REITs trade more on book value than on dividend yield. Eroding book values should have a significant impact on investors’ total returns. Should the book values fall another 10%, you can expect single digit returns from your mREIT investments.
Therefore, protecting book value is critical for mREITs right now.
Concerns of another book value decline
American Capital Agency Corp. (NASDAQ:AGNC) announced that it has already suffered a book value decline similar to the one experienced during the first quarter. Barclays has recently downgraded American Capital Agency to equal weight on concerns of a further decline in the company’s book value despite the recent portfolio rebalancing actions taken by the management. Analysts at Barclays believe that a near-term rally in interest rates could yield upside to the company’s book value. However, the probability of future book value declines overshadows any near-term positive effects.
Another negative conclusion that can be drawn from the recent actions taken by the company’s management is that increased hedging and the reduction in long-term MBS holdings will hurt the company’s earnings potential. That’s why American Capital Agency Corp. (NASDAQ:AGNC) announced a dividend cut of 16.6%. With the new dividend rate in place, the stock is still offering 16.6% yield, much higher than many of its peers.
With leveraged returns and a dividend yield still greater than its peers, I believe American Capital Agency Corp. (NASDAQ:AGNC)should trade at a premium to other Agency mREITs.
High quality non-Agency MBS
Invesco Mortgage Capital Inc (NYSE:IVR) is a hybrid mortgage REIT with investments in residential Agency and non-Agency MBS. It also has investments in commercial MBS. While hybrids are the preferred type of mREITs under the prevailing macroeconomic environment, Invesco Mortgage is not scheduled to benefit as much because of the nature of its non-Agency holdings.
The company owns high quality non-Agency residential MBS, which are less credit-sensitive and more sensitive to changes in the interest rates. Therefore, the company’s non-Agency allocation will not be able to offset the losses within its Agency holdings as much as some hybrid competitors. In the past too, only the commercial MBS held by Invesco helped the company to protect or grow its book value. However, that’s not going to happen this time as this asset class has suffered losses in the current quarter.
Therefore, I would suggest investors stay away from this hybrid mREIT.
Extended duration gap
Among the entire Agency mortgage REITs sector, ARMOUR Residential REIT, Inc. (NYSE:ARR) is in a lot of trouble as it has seen the greatest volatility in its book value. Over the past eight months, its book value plunged 23%. The company has also extended its asset-liability duration gap from 0.2 years at the beginning of May to 1.47 years at the start of June. While further extension in duration gap is highly unlikely under the given circumstances, the present gap is enough to produce another significant decline in the company’s book value it rates continue to rise.
The extended duration gap combined with the recently acquired new production MBS, which perform worse with rising interest rates, will heighten book value volatility. Therefore, I suggest you stay away from ARMOUR Residential.
Conclusion
I believe the management’s recent actions will definitely hinder American Capital Agency Corp. (NASDAQ:AGNC)’s future earnings potential, which could hurt its dividend prospects. While the leverage earnings and the dividend yield are still above its peers, I recommend investors stay away from the stock on concerns of another book value decline. Additionally, ARMOUR Residential’s extended duration gap and Invesco Mortgage’s higher quality non-Agency MBS will cause headaches for both companies.
There’s no question Annaly Capital’s double-digit dividend is eye-catching. But can investors count on that payout sticking around? With the Federal Reserve keeping interest rates at historically low levels, Annaly has had to scramble to defend its bottom line.
Adnan Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
The article Barclays Is Bearish on American Capital Agency originally appeared on Fool.com.
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