The continued speculation regarding the timing of the Fed’s tapering of MBS purchases has led to significant interest rate volatility since the start of this year. In its latest Fed Open Market Committee statement, Ben Bernanke again linked tapering to an improving economy rather than giving a specific time frame. Whether or not tapering begins in three months or nine months, I believe it’s coming to haunt the mortgage REITs as there is still meaningful risk of further book value erosion. Given the situation, the hybrids are the preferred mortgage REITs. Now I’m sure you must have come across this sentence a billion times. So, what news in this article?
This article will feature two hybrid mREITs investors should stay away from because, in my opinion, they are positioned to report significant book value erosion. Let’s see how.
Are Agency mREITs Alone?
The second quarter of the current season is about to end and the earnings season about to commence. For mortgage REITs, I believe the season will be overshadowed with book value erosion across the board. That’s because rates have further rallied in April and the selling off is still material, causing the mREITs that invest exclusively in fixed rate Agency MBS (American Capital Agency Corp. (NASDAQ:AGNC) & ARMOUR Residential REIT, Inc. (NYSE:ARR)) to suffer severe declines throughout the quarter.
However, on the other hand, the non-Agency MBS and other credit assets are less sensitive to interest rates, causing the hybrid mortgage REITs to perform better than the aforementioned Agency mREITs. In a research report to its investors, analysts at Barclays calculate that, in some cases, the positive effect from credit assets was enough to mitigate downward pressure from losses suffered by other asset classes.
More like Agency mREITs
Javelin Mortgage Investment Corp (NYSE:JMI) is relatively new in the mortgage markets and is being managed by the same external manager that is managing ARMOUR Residential. Javelin is among the least popular mREITs of analysts at Credit Suisse and Barclays. It’s down 29% since the start of the year while it yields 20.6% in dividends. It recently declared its third quarter dividend payout. In contrast to popular views, it maintained its dividend rate.
The reason why analysts are not very positive on Javelin Mortgage Investment Corp (NYSE:JMI) is the nature of its investment portfolio. A large chunk of its investment portfolio is fixed rate Agency residential MBS that are highly sensitive to changes in interest rates. At the end of the first quarter of the current year, Javelin reported that only 11% of its investment portfolio comprised of non-Agency MBS. Further, the mREIT is expected to lose due to an extended duration. From -0.15 years, the duration reached 1.71 years as of June 7, 2013. This exposes the company to significant book value erosion. These factors bring Javelin closer to the Agency mREITs and away from hybrids.
More Agency holdings
Invesco Mortgage Capital Inc (NYSE:IVR) is another hybrid mREIT with a market cap of around $2.4 billion and a dividend yield of 14.7%. It also declared its second quarter dividend, which was in line with the first quarter’s shareholder distribution.
The situation at Invesco Mortgage is a little better than Javelin Mortgage Investment Corp (NYSE:JMI)’s. However, Invesco Mortgage is still an mREIT I would recommend investors stay away from. That’s because of the nature of its investment portfolio. At the end of the first quarter, around 70% of Invesco Mortgage Capital Inc (NYSE:IVR)’s portfolio was invested in Agency residential MBS. Around 17% is non-Agency RMBS, while another 11% is commercial MBS. The 30-year fixed rate security, part of which the management at American Capital Agency Corp. (NASDAQ:AGNC) got rid of, is around 57% of Invesco’s entire portfolio. This security is considered to be highly sensitive to interest rates and its price moves inversely proportional to rate changes. Therefore, its abundance will expose the company to significant book value erosion during the current quarter.
Competition
Both Invesco Mortgage Capital Inc (NYSE:IVR) and Javelin Mortgage Investment Corp (NYSE:JMI) compete with Two Harbors Investment Corp (NYSE:TWO) to purchase non-Agency and Agency paper. The stock is yielding 11.5% on its recently announced quarterly dividend rate of $0.31 per share. The company has remained a favorite of analysts at Deutsche Bank, Barclays and Credit Suisse. In a recent investor presentation, the company’s management also disclosed that its book value has remained unchanged from the end of the first quarter. Let’s see what made it possible.
Even though Two Harbors Investment Corp (NYSE:TWO) also has a relatively large Agency MBS holding, it is expected to benefit from its new investments, which include credit sensitive assets and mortgage servicing rights (MSRs). The increased presence of credit sensitive loans makes Two Harbors’ book value less interest rate sensitive. A stronger economy depicted by the rising interest rate environment drives their prices up as risk of default diminishes. So, in fact the book value moves proportionally to changes in interest rates, partially offset by the inverse relationship between the book values of Agency MBS and interest rates. The addition of MSRs will act to further increase the company’s earnings.
Conclusion
Given the volatility in the mortgage markets, I recommend investors don’t invest across the hybrid mortgage REIT space without looking at the prospects of each hybrid mREIT individually. Currently, Invesco Mortgage Capital Inc (NYSE:IVR) and Javelin Mortgage Investment Corp (NYSE:JMI) are not positioned to benefit. However, Two Harbors Investment Corp (NYSE:TWO) is.
Adnan Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
The article Some Hybrids Need to Be Avoided on Book Value Concerns originally appeared on Fool.com.
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