What's Wrong With This mREIT?

Zain is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

American Capital Agency (NASDAQ: AGNC) has been one of the star performers in the mortgage REIT sector since its inception in 2008. However, the recent performance of this mREIT is something to worry about as the stock price has dropped rapidly over the past few weeks.

What’s going on in the mREIT Sector?

Agency mortgage REITs like American Capital Agency invest in long duration mortgage backed securities (MBS) that are backed by the government. They finance these investments using short-term funding from repos and make money from the spread between the higher return on their MBS investments and lower short-term borrowing costs. This spread is then levered up to magnify the returns.

In the recent past, the Fed has kept the long-term interest rates artificially low by intervening in the long-term mortgage and treasury bonds market through its quantitative easing programs. This had the effect of reducing the interest rate spread for mortgage REITs, but at the same time, inflated the prices of the securities held by these mortgage REITs, which resulted in rising book values for the sector.

However, now the market has started to anticipate that the Fed is about to end its QE program. As a result, bond yields have started to rise which has the impact of damaging the book values for the mortgage REITs.

Why the underperformance?

In its first-quarter earnings results, American Capital Agency reported that its book value per share declined 8.6% due to rising yields on mortgage bonds. Interest rates have risen further since the results were announced and the stock has dropped more than 20% over the past three months. At the same time, the iShares FTSE NAREIT Mortgage REITs Index ETF has dropped more than 10% during this period.

American Capital Agency has underperformed over the past few months in response to rising long-term interest rates for the very same reasons that it had outperformed its peers during the low interest rate environment: its portfolio is designed for a low interest rate environment. American Capital Agency has paid premium prices to acquire securities with low prepayment risk such as lower loan balance HARP securities. This strategy helps American Capital Agency against prepayments as mortgage owners pay early to refinance at lower interest rates, thus forcing mortgage REITs to reinvest in lower yielding securities.

While MBS securities with low prepayment risk were in high demand and attracted big premiums as long-term rates were falling, the attractiveness of such securities is severely reduced as prepayments and refinancing activity naturally falls when interest rates rise. As a result, these securities see a much sharper fall in value as compared to generic mortgages, treasury bonds, or interest rate swaps that are used to hedge the interest rate risk. That is why American Capital Agency is underperforming its competitors in a sector that is taking a hit from rising interest rates.

How are competitors faring?

American Capital Agency’s competitors that have invested heavily in fixed-rate 30-year MBS are suffering as well.

In its first-quarter earnings results, ARMOUR Residential (NYSE: ARR) reported that its book value per share dropped 8% for the quarter. The first-quarter results showed that ARMOUR Residential was heavily invested in 30-year fixed rate MBS with smaller investments in 20-year, 15-year, and hybrid ARM securities. Despite having a more diversified portfolio than American Capital Agency, I expect ARMOUR Residential to perform worse because its leverage of 9.17 times at the end of the first-quarter was much higher than American Capital Agency’s leverage of 5.7 times.

Similarly, Annaly Capital Management’s (NYSE: NLY) book value per share dropped 4.2% during the first-quarter. Annaly Capital Management is similar to American Capital Agency in that it invests a large proportion of its capital in fixed-rate 30-year MBS. However, one important difference between Annaly Capital Management and American Capital agency is that American Capital Agency is far more exposed to securities with low prepayment risk that are highly sensitive to rising interest rates.

Moreover, Annaly Capital’s recent acquisition of CreXus Investment will help it diversify into commercial real estate which may perform better as the economy improves. That is why I expect Annaly Capital Management to do better than American Capital Agency in a rising interest rate environment.

Foolish bottom line

The mREIT sector in general, and American Capital Agency in particular, have been a darling of yield starved income investors as the Fed’s actions created a low and stable interest rate environment. However, the recent rise in interest rates has sent American Capital Agency tumbling since its portfolio is currently designed for a low interest rate environment. I would advise investors to stay away from American Capital Agency for now because a further rise in interest rates would have an adverse impact on its book value, and thereby its stock price.

There’s no question Annaly Capital’s double-digit dividend is eye-catching. But can investors count on that payout sticking around? With the Federal Reserve keeping interest rates at historically low levels, Annaly has had to scramble to defend its bottom line. In The Motley Fool’s premium research report on Annaly, senior analysts Ilan Moscovitz and Matt Koppenheffer uncover the key challenges the company faces and divulge three reasons investors may consider buying it. Simply click here now to claim your copy today!

Zain Zafar has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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