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American Capital Agency Corp. (AGNC), Annaly Capital Management, Inc. (NLY): Mortgage REITs, A Long-Term Bet

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American Capital Agency Corp. (NASDAQ:AGNC)The Federal Reserve once again linked the unwinding of QE to improvements in the financial and macroeconomic conditions of the country. As the economy continues to give mixed signals, I believe Ben Bernanke’s recent speech will further fuel speculations about the end of asset purchases. The markets have already priced in the effect of a tapering, causing volatility in the interest rates. So, regardless of the halt in asset purchases, I believe that there is one sector that is attractively valued. Let’s see which sector it is.

Imagined improvements

Bloomberg reported Ben Bernanke as saying that the asset purchases are by no means on a preset course. In simple words, he linked a halt in asset purchases to improvements in the economic and financial conditions of the country. Besides inflation, the central bank is particularly monitoring the U.S. labor and housing markets for signs of improvements. The asset purchases could even be prolonged until the ‘imagined improvements’ are not seen.

Priced in

Speculations and confusion surround the unwinding of asset purchases has hurt mortgage REITs the most. The markets started pricing in the effect of the Fed’s exit since the first quarter, and as a result, we saw a rise in interest rates.

The yield on 10-year Treasury was 1.75% on the day when Fed announced the launch of QE3, compared to 2.57% now, while the 30-year fixed mortgage rate was at 4.09%, compared to 4.51% now. It shows that rates have risen over pre-QE3 levels, meaning much of the QE3 unwinding effect is already priced in.

Skydive

I believe mortgage REITs have suffered the most, given this rise in interest rates amid speculations about the Fed’s exit. Mortgage REIT EFT (MORT) has plunged 17% over the past three months, while mortgage REITs like American Capital Agency Corp. (NASDAQ:AGNC), Annaly Capital Management, Inc. (NYSE:NLY) and ARMOUR Residential REIT, Inc. (NYSE:ARR) have experienced declines of 23%, 13%, and 30%, respectively, since the beginning of the year.

Mortgage REITs saw these declines as prices of their fixed income portfolios are inversely proportional to changes in interest rates, causing mortgage REITs’ book value to plunge when the rates increase. Since their MBS holdings are the only assets, the stock price follows the plunge in the book values.

Oversold and undervalued

The declines in the stock prices of the aforementioned mREITs lead me to believe that they have been oversold and undervalued. Looking at the price-to-book value multiples, I see American Capital Agency Corp. (NASDAQ:AGNC) trading at 23% discount to its first quarter book value. Similarly, Annaly Capital Management, Inc. (NYSE:NLY) and ARMOUR Residential REIT, Inc. (NYSE:ARR) are trading at 21% and 39% discounts, respectively.

Since the second quarter is already over and the book values are expected to fall, the use of first quarter book value does not seem an ideal parameter to determine valuations. So, I used the estimated second quarter-end book values provided by Barclays PLC (ADR) (NYSE:BCS).

Using the estimated figures provided by analysts at Barclays PLC (ADR) (NYSE:BCS), I see American Capital Agency Corp. (NASDAQ:AGNC) trading at 12% discount, while Annaly Capital Management, Inc. (NYSE:NLY) and ARMOUR Residential REIT, Inc. (NYSE:ARR) are trading at 10.7% and 21%, respectively. These significant discounts lead me to believe that these stocks are attractively valued right now.

For a stock to be attractively valued, it has to be both undervalued and estimated to increase in price due to either company specific or macro factors. While we have noticed that the stocks are undervalued, let’s see why I believe they will increase in price in the coming future, which makes them attractively valued.

Long-term perspective

I am sure you must have come across a lot of negative sentiment about the outlook of the mortgage REITs sector, but these sentiments ignore the longer-term outlook. We have already established that one effect of rising rates is the decline in the book values. However, what investors fail to understand is that there is another effect which tends to increase the spread for mortgage REITs.

Both these effects come into play at different times. The decline in book values is the short-term effect, while in the longer-term, mortgage REITs are expected to report expansion in their net interest spreads as they continue to deploy more capital to acquire new production MBS.

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