Amid mREIT Headaches, This Company Is Confident

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Investment Strategy

Overall MBS prepayment speeds have declined during the month of November. However, prepayment speeds on higher coupon securities have increased, which are causing headaches for Annaly Capital (NYSE: NLY). Compared to American Capital Agency (NASDAQ: AGNC) and Armour Residential (NYSE: ARR), Annaly Capital own securities with higher coupons. Among the three REITs, Annaly also has the highest prepayment speed for its MBS portfolio. Annaly was also forced to cut its dividend for the fourth quarter, while American Capital maintained its quarterly dividend. These are the reasons why I am more confident about the future of American Capital and Armour Residential. Therefore, I am bullish on AGNC and ARR. I have a neutral rating for Annaly Capital.

Mortgage Market Update

Overall prepayments speeds declined during the month of November. However, speeds on higher coupon securities increased during the month for both, 30-year and 15-year fixed rate agency securities. The prepayment speeds on 30-year MBS decreased on average 8% month over month to 29.9% CPR. FN and FH 15-year speeds were at 22.6% and 24.5% CPR, respectively. While the corresponding 30-year MBS have prepayment speeds of 29.6% and 30.3% CPR, respectively.

Annaly Capital

Despite the fact that the Federal Open Market Committee of the Fed chose to increase Treasury purchases to replace Operation Twist instead of increased MBS purchases, Annaly Capital Management is facing tremendous pressure as far as its net interest margin is concerned. Annaly stands to be the largest Agency-only mortgage REIT in the US, with a market cap of $13.9 Billion. Securities other than Agency MBS are allowed to be included in the company's portfolio as long as they don't exceed 25% of the total assets. Looking at the situation, the company's management proposed the acquisition of the remaining portion of CreXus Investment (CXS). However, the management of CreXus does not seem to be in any hurry to evaluate the proposal made by Annaly Capital.

Prepayment Headaches for NLY

The weighted average coupon on the holdings of Annaly Capital at the end of the third quarter decreased from 4.55% to 4.10% at the end of the same quarter of the prior year. However, the weighted average purchase price increased to 103.7% from 102.3% a year ago, exposing the company to more amortization costs. The company reported an average prepayment speed of 20% at the end of the third quarter of the current year.

In comparison both, American Capital Agency and Armour Residential have lower average coupons on their holdings. At the end of this year's third quarter, AGNC reported 3.86% average coupon, up from 2.81% a quarter ago. Armour Residential reported an average coupon of 3.54% on its Agency securities at the end of this year's third quarter. The weighted average expected CPRs for American Capital and Armour Residential are 12% and 13%, respectively. Since both have lower coupon securities compared to Annaly Capital, both face favorable prepayment speeds on their MBS portfolios.

Annaly has recently announced a dividend cut. The quarterly dividend was cut from its previous $0.5 per distribution to $0.45 for the fourth quarter. Though the magnitude of the cut was lower than what analyst were expecting, it does reflect the fact that the company's operating income is facing increased downwards pressure.

Valuations

The mortgage REITs are currently trading at a 7% discount on average to their estimated fourth quarter book values and yielding 13.2%. Agency-only mortgage REITs are trading at a 7% discount to their hybrid peers which is why they provide better relative value. While hybrid REITs have an edge as they can invest across the entire mortgage universe, Agency-only REITs offer better value given their valuation discount. Among Agency-only, American Capital Agency remains my top pick along with Armour Residential. The following table summarizes the valuations of some of the mortgage REITs mentioned in the report.

Conclusion

I continue to favor hybrid mortgage REITs. However, among Agency-only mortgage REITs, the ones with prepay protected portfolios will have more stable cash flows from lower reinvestment needs. AGNC, ARR, Apollo Residential (AMTG), Invesco Mortgage (IVR), American Capital Mortgage (MTGE) and Two Harbors (TWO) have the lowest and most stable prepays in the sector.


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