During the second quarter, we saw mortgage REITs nosedive on fears of significant book value declines due to the expected slowdown in the Federal Reserve’s stimulus and the resultant rising interest rates. Given the situation, some analysts recommended investors buy hybrids as their book values were expected to report lower declines compared to Agency-only mREITs. A couple of hybrids have reported their performances for the second quarter. Let’s see whether these hybrids were able to outperform their Agency-only counterparts during the quarter as expected or not.
Rising rates cause net interest spreads to widen and the book values to decline, while prepayments slowdown. So, these three metrics will be analyzed in the article.
Hybrid vs. Agency-only
Before comparing the performances of Agency and hybrid mREITs, you should be clear about their differences. So, for those of you who are not, Agency mREITs invest in MBS that are issued and guaranteed by the U.S. government Agencies only. Hybrid mREITs invest in Agency and non-Agency (also known as private-label) MBS. Since non-Agency MBS don’t have government backing, they expose mREITs to default risk. To offset this risk, they offer higher returns compared to Agency MBS.
Why hybrids were preferred?
Under QE3, the Fed has committed itself to buying Agency MBS with certain attributes in order to keep the mortgage rates low. This created downward pressure on Agency MBS prices. As a result, the mREITs that owned these MBS were expected to face significant book value declines. As a result, hybrids that invested in assets other than Agency MBS were expected to outperform their Agency-only counterparts. Let’s see whether that actually happened or not.
Expected disappointment
Hatteras Financial Corp. (NYSE:HTS) is primarily invested in Agency residential MBS that are backed with single-family loans. These Agency securities are both fixed-rate and adjustable-rate mortgage (ARMs). So, the company can be classified as an Agency-only mREIT. At the end of the second quarter, it reported EPS of $0.60, $0.04 per share behind the consensus mean estimate.
This is not the only disappointment. Since, Hatteras Financial Corp. (NYSE:HTS) is an Agency mREIT, it reported a 21.3% sequential decline in its book value and an 18 bps decline in its net interest spread over the same time period. Also, the prepayment speeds (measured by CPR) increased from 19% in 1Q to 20.8% at the end of the second quarter. During the same time period, the company increased its leverage from 7.4 times to 9.3 times its shareholder equity.
We have seen how an Agency mREIT performed during the quarter, now let’s see how the hybrids have been able to cope up with the situation.
Impressive beat
Dynex Capital Inc (NYSE:DX) is a hybrid mREIT. The company reported second-quarter earning per share (EPS) of $0.54, $0.22 per share above analysts’ consensus estimate. This is a significant earnings beat.
While the company is classified as a hybrid, it has a large concentration in the troubled Agency MBS. At the end of the second quarter, the company disclosed that nearly 68% of its investment portfolio was the residential Agency MBS, which caused the company to report nearly 15% decline in its book value.
At the same time, the company also reported a 14 bps decline in its net interest spread over the linked quarter. The prepayment speeds increased to 21% from 14.3% a year ago. So, despite being classified as a hybrid, I believe Dynex Capital Inc (NYSE:DX)’s second quarter was a disappointment. During the quarter, the company also increased its leverage from 6.3 times to 6.8 times. This, I believe further contributed in bringing the book value down.
Management believes that it was the widening of the credit spread during the quarter and not the rising rates that led to the massive book value declines in hybrids. So, the hybrids had no advantage over their Agency-only counterparts when it came to preserving book value.
Desired diversification
You must be wondering what led Invesco Mortgage Capital Inc (NYSE:IVR) to report lower book value and net interest spread declines, while the aforementioned mREITs faced tremendous pressure. The reason is the design, structure, and diversification provided by Invesco Mortgage Capital Inc (NYSE:IVR)’s portfolio. First, only 53% of its portfolio is composed of the troubled long-term Agency MBS. Second, the rest of the portfolio is divided into ARMs, hybrid ARMs, Agency collateralized mortgage obligations, non-Agency residential MBS, and commercial MBS. So, it provides more diversification than the aforementioned mREITs’ asset portfolios.
Conclusion
So, we have seen that the mere classification as a hybrid mREIT is not enough. Investors need to be sure that their hybrid mREITs portfolio is invested across the entire mREIT eligible asset space in order to provide some cushion to the book value. Otherwise, your hybrid mREIT will face similar pressures on book value and net interest spread. Invesco Mortgage Capital Inc (NYSE:IVR) provides that desired diversification. So, I am bullish on the stock.
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 Is Mere Hybrid Classification Enough to Buy a mREIT? originally appeared on Fool.com is written by Adnan Khan.
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