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Agency Mortgage REITs Continue To Hold Their Own In Tough Markets
ETF Channel Staff - Monday, September 26, 12:58 PM

Article by Frank M. Bifulco, CFA - Alcott Capital Management

With football season now upon us, it is appropriate that Agency Mortgage REITs have lived up their reputation as defensive stalwarts, like a modern-day Monsters of the Midway for turbulent investing times. Essentially leveraged bond funds with 100% government-backed mortgage-backed securities (MBS), the Agency MREITs have lately been subjected to a series of negative but largely irrelevant news headlines. Concerns have arisen regarding the value of MBS collateral after a U.S. government debt downgrade, repurchase agreement (‘REPO’) haircuts rising forcing the companies to use less leverage, government attempts to push through an ‘auto-refi’ program to take advantage of super-low mortgage rates, and finally an SEC review of the mortgage REIT exemptions under the Investment Company Act of 1940. As Roseanne Roseannadanna of “SNL” fame used to say, “It’s always something….”

But price gains are not the reason investors seek out the Agency MREITs. They are a way to take advantage of the very same Federal Reserve policies that have made treasury bonds, money market funds, and CD’s unattractive for most of America’s Middle Class investors. All of the Agency MREITs are borrowing at today’s ultra-low short rates and investing in either short- or long-term MBS products. Even with historically low leverage the sector is able to generate fairly predictable 14-18% yields. In exchange for interest rate and hedging risks, investors assume absolutely no credit risk thanks to the U.S. treasury standing behind the housing agencies that issue the MBS.

Dividend yields averaging 16% have come under pressure in recent months as rates have fallen – Capstead Mortgage (CMO) and CYS Investments (CYS) both recently trimmed their dividends – but the drop in dividends is nothing compared to the drop in other interest rates since the beginning of the year. The 10-year treasury bond was actually at risk of soaring above 4% earlier this year; today it is closer to 1.75%. So dividend yields going from 18% down to 16% doesn’t seem like too much of a drop-off compared to the alternatives.

The flattening yield curve presents a problem going forward as reinvested proceeds from higher-yielding MBS will be purchasing lower-yielding MBS. Spread compression is unavoidable, but even with ‘Operation Twist’ the Fed is committed to an ultra-low rate at the short end of the bond market where the Agency MREITs do their borrowing.

The final hurdle the sector might have to navigate is the current European situation. A systemic or financial blowup overseas would affect global markets directly and would also affect the day-to-day operations of the MREITs since they borrow in the REPO market from many European banks. Fortunately, the sector navigated a tougher obstacle 3 years ago when Bear Stearns and Lehman Brothers both went under. The companies are using much less leverage today (about 7.5x debt/equity today compared to almost 10x in 2008) and have more REPO counterparties with less exposure to the troubled names. A European blowup because of Greece or one of the PIIGS will be a hiccup, but it should be navigable.

Despite these headline negatives, the sector has performed very well in recent months, maintaining an element of price stability while continuing their double-digit dividend yields. A basket of the Agency MREITs holding long maturity mortgages – Annaly Capital Management (NLY), CYS Investments (CYS), American Capital Agency (AGNC), and Armour Residential (ARR) – have all benefited from the decline in long-term interest rates. They have outperformed the S&P 500 by an average of 600 bp over the last 3 months. Short-duration Agency MREITS which specialize in shorter mortgages (like adjustable mortgages instead of 15-year and 30-year fixed) have outperformed much less -- about 250 basis points -- with Anworth Mortgage (ANH), Hatteras Financial (HTS), and Capstead Mortgage (CMO) comprising the short-mortgage play.

The two ETFs in the sector have performed worse than the individual Agency MREIT stocks, with the iShares FTSE NAREIT ETF (REM) matching the decline in the S&P 500 in the last three months, while the Market Vectors Mortgage REIT ETF (MORT) has underperformed by about 250 basis points. Both ETFs include the non-Agency ‘hybrid’ MREITS which invest in non-GSE debt and take on credit risk, precisely the asset class that would be expected to have difficulty during the recent turbulent investing period. They also can include other financial, bank, and REIT shares so understand that neither is a pure-play on the Agency or Hybrid MREIT sectors.

Full List of REM Holdings

Full List of MORT Holdings


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