Bernanke’s Words Look Promising for mREITs

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As the world readies for a tapering of QE3, interest rates have adjusted for an eventual Fed exit. The 10-year US Treasury yield sits at 2.53%, up from 1.6% in May.

10 Year Treasury Rate data by YCharts

Long-dated maturities see the biggest change. Mortgage-backed securities took a beating on the Fed’s words of a taper, but yields have since come off their highs.

Let’s examine how this plays out for mREIT investors.

Bernanke’s reversal

It first appeared that the Federal Reserve would begin tapering by the end of 2013, if not September 2013, a month cited in several analysts’ reports. The market responded quickly, pushing yields higher.

Since then, Bernanke has stepped off the tapering talk. He said yesterday that the Fed’s purchases “are by no means on a preset course,” adding that the Fed will be “responding to the data.” In essence, Bernanke’s not sold on the taper if economic reports show a slowing economy.

Bernanke’s latest move is genius. In announcing a potential tapering of asset purchases, Bernanke forced the markets to move rates up, without any exit from the Fed. The Fed is buying the same amount of U.S. Treasuries and mortgage-backed securities, however the market responded as if the Fed pulled out completely.

Bernanke slowed any bubble that may have been forming, all the while enabling the Fed to justify perpetual asset purchases in excess of $1 trillion each year.

Why mREITs should succeed

Mortgage REITs are the most exposed to higher rates. Mortgage REITs borrow in the short-term to invest in long-term securities. They use leverage, up to 8x their equity, to generate double-digit yields for investors.

In effect, an mREIT will borrow at 2% and lend (invest in MBS products) at 4-5%, paying out the spread to investors.

Bernanke’s latest signal suggests that he’s happy with rates on the long-end of the yield curve. Higher rates dampen discussion about a real estate bubble, while slowing speculative credit issuance and record borrowing.

Higher rates also bode well for mREIT profitability. As long-dated yields find a new plateau at 4.5% for 30-year mortgages, mREITs earn a larger spread between short and long-term rates.

mREITs in Focus

The two largest mREITs, American Capital Agency (NASDAQ: AGNC) and Annaly Capital Management (NYSE: NLY) should fare better than their share prices let on.

Mortgage REITs produce earnings and losses from two different mechanisms. First, there are the underlying book values, which change in response to rates. Higher rates mean lower MBS prices, and thus lower book values. Lower rates mean higher MBS prices, and thus higher book values.

This sector is especially levered to quick jumps in rates because their portfolios are levered. If MBS prices drop 5%, for example, book value may fall by 30% or more due to leverage. We watched this happen in the most recent market rout, as book values tumbled across the board.

Secondly, mREITs generate gains or losses from interest spreads. If an mREIT borrows at 2% to buy a portfolio of mortgage-backed securities at a yield of 5%, it earns 3% per year on the investment. Levered at 8-to-1, it could earn 24% per year on its equity investment. This explains why mREIT dividend yields are so high.

The best case scenario is here

I previously wrote about the mREITs’ responsiveness to Bernanke’s tapering, noting that I did not expect a worst case scenario. A worst case scenario is one in which rates rise very quickly, MBS values plummet, and mREITs become insolvent as they owe more to creditors than their packaged mortgage securities are worth on the market.

Given Bernanke’s recent words about an eventual taper, it seems 30-year mortgage rates may teeter around 4.5% for quite some time while short-term rates remain stuck on their historical lows. Bernanke may not taper at all in 2013. Besides, tapering must come before a rise in short-term interest rates. The mREITs’ spreads are just fine.

 Thus, I think now is the best time to own mREITs as they can deploy capital into new mortgage-backed securities at higher rates, earning a larger spread.

I’m going long American Capital Agency here on CAPS. Ultimately, I believe the Fed’s taper is priced in, and upon the Fed’s exit, mortgage-backed securities will experience only minimal increases in rates. The market priced Bernanke’s next move in, and mREITs can tolerate very slow increases in 15- and 30-year mortgage rates.

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