Bloomberg reports that mortgage rates have climbed to their highest in a year despite the Fed’s continuous efforts to curtail them through its MBS buying program. The rise in the mortgage rates signals strength in the US economy in general and the housing market in particular.
The average 30-year fixed mortgage rate jumped 22 bps to 3.81% over the prior year, while the 15-year fixed rate climbed 21 bps over the same time frame. The yields on the 10-year US Treasury reached 2.23%, its highest since April last year.
The markets have started to price in a halt in the stimulus efforts, as Ben Bernanke has mentioned that the Fed could begin to scale back stimulus if the employment outlook shows sustainable improvement. While the Fed’s exit would certainly mean higher mortgage rates, which will translate into widened mortgage spreads for mREITs, it will also mean a decline in book values.
Given the situation, this article will feature the mREITs that will gain and lose depending on the structure of their investment portfolios.
Why hybrids will gain?
The key to mortgage REIT sector right now is book value preservation. Given the continued strength of the non-Agency MBS market, hybrid mortgage REITs have been able to withstand the volatility of the market better. This protection of book value leaves the hybrid mortgage REITs in a better position to take advantage of the better spread environment on Agency MBS today.
I believe Two Harbors Investment Corp (NYSE:TWO) is the hybrid mortgage REIT that is best positioned for the prevailing macroeconomic environment. The company has a very well diversified investment portfolio of residential mortgage backed securities, both Agency and non-Agency. Besides, the company has a portfolio of real estate facilities which generates rental income for the company. Therefore, there are two diverse revenues streams for the company.
Further, it has constructed its portfolio in a way that the company will benefit from an increasing interest rate environment. You can expect the company to report around a 7% increase in its net interest income if the rates climb 50 bps.
Two Harbors Investment Corp (NYSE:TWO) has a track record of investing in alternative MBS investments, and its further diversification in other asset classes, including whole loans and excess MSRs, will continue to differentiate and provide support to the company’s bottom line, justifying a premium.
My bullishness on Two Harbors Investment Corp (NYSE:TWO) is also shared by the company’s insiders, who have confidence in the company’s future. In fact, during May the company saw 15,000 shares bought (open market) by two of its directors at an average price of $11.46 per share.
ARMOUR biggest loser
ARMOUR Residential REIT, Inc. (NYSE:ARR) has faced tremendous difficulties since the launch of QE3. Its net interest rate spread contracted, causing dividend cuts twice during the prior year. Besides this (or perhaps due to it), the company has depreciated 13% in value since the beginning of the year. This is the worst performance among the Bloomberg index of 33 mREITs.
Recently, ARMOUR Residential REIT, Inc. (NYSE:ARR) raised equity, which was used to finance new production MBS, which perform better during a low interest rate environment. However, these bonds perform worse when rates go up. ARMOUR Residential REIT, Inc. (NYSE:ARR) has built a portfolio that will not benefit from a rising interest rate environment. In fact, you can expect the company to report around 4% drop in its net interest rate, if the interest rates go up by 50 bps.
The case in not different at Javelin Mortgage Investment Corp (NYSE:JMI), which was also founded by Ulm and Zimmer, who founded ARMOUR Residential REIT, Inc. (NYSE:ARR). Javelin Mortgage Investment Corp (NYSE:JMI) is currently the second-worst performer among mREITs. JAVELIN is like ARMOUR Residential REIT, Inc. (NYSE:ARR), but it’s allowed to invest in non-Agency bonds, such as subprime debt. This helps the company diversify its risk and exposures to changes in interest rates and the Fed’s interventions.
Unlike Invesco Mortgage Capital Inc (NYSE:IVR), JAVELIN’s sole source of funding is through the repo markets. Given JAVELIN’s high leverage of 7.9 times and a cost of funds of 1.03%, any disruptions in the repo markets could have a magnified impact on the company’s sources of funding.
With a 50 bps increase in the interest rates, you can expect the company to report around 8% decline in its net interest income. This is troublesome, particularly when analysts in general are anticipating volatility in the interest rates as the Fed weighs an exit.
The article The Best and Worst mREITs Amid the Fed’s Exit originally appeared on Fool.com.
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.
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