2013 Outlook For Non-Agency REITs
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With the available returns lower on Agency mortgage backed securities, I expect 2013 to be a year where the mortgage REITs look to expand their investment opportunity sets. The return environment in 2012 remained very attractive for non-Agency MBS. I remain constructive on the sector because the strong demand from investors in search of yield given ultra low rates, continued improvement in the underlying fundamental performance. Assuming leverage remains consistent with 2012 levels, I see loss adjusted-yields at 4-6% and the ability to still generate returns in the 10-12% range. However, the availability of leverage has increased, which would allow mortgage REITs to gradually increase non-Agency returns.
Book Value Expectations
The sector posted strong returns during 2012, still non-Agency MBS remain cheap on a loss-adjusted basis relative to other credit assets and the search for yield should translate into strong demand. In addition, I expect the US housing market recovery to continue into 2013. The situation in Europe, a soft domestic economy and a weak US labor market are some of the potential headwinds. Overall, I believe this should provide stability with potential for modest appreciation in book values.
Additional Investment Opportunity
Since returns available on traditional MBS are lower, I expect mortgage REITs in 2013 to expand to additional investment opportunities including mortgage servicing rights [MSR], new loan securitizations and subordinated credit tranches of GSE risk. I see increased capital allocations during 2013 for these investment opportunities.
Given the current pipeline, Credit Suisse expects $2-3 billion of market potential for excess mortgage servicing rights over the next 12 to 18 months. Additional business is expected as more and more banks in the US get rid of the non-core high cost servicing creating opportunity for excess servicing. I see mortgage REITs natural buyers of the excess servicing rights, given the attractive returns compared to the MBS markets. Among others, PennyMac Mortgage Investment Trust (NYSE: PMT) and Newcastle Investment (NYSE: NCT) should benefit from this increased availability and relatively higher returns provided by mortgage servicing rights. PennyMac experienced solid MSR portfolio growth during the third quarter. The portfolio swelled from $32.8 billion at the end of the second quarter to $65.2 billion. The company seeks to grow its non-Agency MSR investments as the non-Agency improves further. For Newcastle, the MSR portfolio produced 19% return on equity in the year 2012. This is above the 17%-18% target the company set earlier. It appears that both the companies are already taking advantage from their MSR investments and expect to further benefit.
Under the current scenario, where government guaranteed originations dominated, new private securitizations remained modest in 2012 totaling $5 billion, according to a report by Credit Suisse to its investors. A combination of factors in 2013 would lead to higher private label securitizations. These include, tightening of senior spreads, lower enhancement level and higher guarantee fees on Agency mortgages. However, regulatory risk including risk retention rules are potential headwinds, which need to be resolved to make further progress. I expect PennyMac and Newcastle to benefit from this attractive opportunity. Besides, I believe Two Harbors (NYSE: TWO) and Invesco Mortgage (NYSE: IVR) will explore the opportunity during 2013.
Valuations
PennyMac trades at 25% premium to its book value, compared to 53% premium for Newcastle. Comparatively, hybrid REIT, Invesco Mortgage Capital trades at 5% discount to its third quarter book value, while Two Harbors trades in line with its book value. This reflects the fact that the market in general is taking the future growth for PennyMac and Newcastle into account, which is why they are trading at a premium to the other mortgage REITs mentioned.
Top Picks
PennyMac and Newcastle are among my top picks within the non-Agency mortgage REITs sectors of the US. Both have a specialized business model that is less susceptible to spread compression in the MBS markets. I also expect a hike in dividends for both in 2013, which is in contrast to the Agency mortgage REITs, like Annaly Capital, American Capital Agency and Armour Residential. Diversification attempts by Invesco and Two Harbors will prove beneficial given their current cheap valuations. Therefore, investors should keep an eye on such news from both the companies.
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