A few weeks ago, an Agency mREIT, CYS Investments Inc (NYSE:CYS), reported a worse than expected book value decline when it disclosed its second-quarter performance. Back then, I thought it would be a concern for the rest of the Agency mREITs. Now, Capstead Mortgage Corporation (NYSE:CMO) is out with its second-quarter results. Let’s compare and contrast these two performances and see why I still prefer hybrids over their Agency-only counterparts.
Book value and spread decline
Capstead Mortgage Corporation (NYSE:CMO) is an Agency mREIT that invests largely in adjustable-rate securities. Capstead Mortgage reported earnings per share (EPS) of $0.27, which was $0.05 per share behind the consensus estimate. Book value plunged 5.9% over the prior quarter.
Book value decline with expansion in spread
As noted above, CYS Investments Inc (NYSE:CYS) is a similar mREIT, however, with large investments in fixed rate MBS. It reported a 26% decline in its book value over the prior year, while it was able to expand its net interest rate spread by 20 bps over the prior quarter.
During the quarter, CYS Investments Inc (NYSE:CYS) seems to have accumulated the 30-year fixed rate security, while the 15-year fixed rate security that the company held outperformed. While the 15-year MBS outperformed, CYS sold some of it to purchase the 30-year MBS that is considered highly sensitive to changes in interest rates. I believe that’s the reason behind the massive book value decline that CYS Investments reported.
Let’s look at how the company reported an expansion in its net interest rate spread. Over the prior quarter, the average asset yields increased 30 bps, while the cost of funds increased only 10 bps, leading the company to report a 20 bps increase in the spread. However, much of the increase in the asset yield was associated with the 15-year MBS.
Looking ahead
Given the scenario, Two Harbors Investment Corp (NYSE:TWO) is one of the most favored mREITs as it’s classified as a hybrid mREIT with investments in both Agency and non-Agency MBS. The company is scheduled to report its second-quarter results on Aug. 6, 2013.
During the second quarter, Two Harbors Investment Corp (NYSE:TWO) increased its portfolio balance, which should increase its net interest income. Analysts at Barclays expect that Two Harbors is scheduled to report as much as 8 bps expansion in its net interest rate spread, driven by higher yield on its credit sensitive assets.
These credit sensitive investments should also help Two Harbors Investment Corp (NYSE:TWO) in the second half of the current year. Additionally, Two Harbors is expecting incremental income from its mortgage servicing rights (MSRs). Two Harbors recently got approval from Ginnie Mae, Freddie Mac, and Fannie Mae. Management believes that its MSRs are an attractive investment opportunity as they act as a natural hedge against further interest rate rises.
Since Two Harbors Investment Corp (NYSE:TWO) has a combination of Agency and credit sensitive assets, its book value is expected to post a decline of 2.5% over the prior quarter. This should be one of the lowest declines in the mortgage REIT space.
Why I prefer hybrids?
You might still be wondering why I prefer hybrids over Agency mREITs. I prefer hybrids because besides investing in the Agency securities, hybrids have investments in credit sensitive assets. Additionally, Two Harbors Investment Corp (NYSE:TWO) has investments in MSRs that act as a natural hedge against rising interest rates. We saw how CYS Investments Inc (NYSE:CYS) and Capstead Mortgage Corporation (NYSE:CMO) reported significant declines in their book values. So, Two Harbors has the ability to report one of the lowest declines in book value with an expansion in its spread.
Adnan Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
The article Book Value Still the Biggest Concern for mREITs originally appeared on Fool.com.
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