The mortgage REITs space is in a lot of trouble right now as speculation regarding the Fed’s tapering off of its quantitative easing program has led to an increase in long term interest rates. Investor favorites like American Capital Agency Corp. (NASDAQ:AGNC) and ARMOUR Residential REIT, Inc. (NYSE:ARR) have witnessed the sharpest price declines in recent weeks due to fears about the decreasing value of the MBS securities held by these agency mREITs. In such an environment, I believe that Capstead Mortgage Corporation (NYSE:CMO) is the safest bet in this space.
mREITs in free fall
The reason for the recent downfall of the mREIT sector relates to the rise in yields of the MBS securities held by them. Recall that the price of a (mortgage) bond is inversely related to its yield. Therefore as the talk of the Fed ending its QE gathers pace and yields rise, the prices of the securities held by mREITs fall, resulting in a drop in the book value per share for the mREITs. It is also important to note that the extent to which a bond’s price is sensitive to interest rate movements is measured by the bonds’ duration. A bond’s duration is proportional to its time to maturity, but inversely related to a bond’s coupon rate.
Capstead’s advantages
Once you understand the relationship between a bond’s yield, its price, and its duration, it is very easy to see why Capstead Mortgage Corporation (NYSE:CMO) is the mREIT to be in right now. Capstead Mortgage Corporation (NYSE:CMO) follows a very conservative investment strategy and invests almost exclusively in ARM agency securities. Unlike fixed-rate MBS that have a fixed coupon rate throughout their lives, Adjustable Rate Mortgage, or ARM securities, pay a coupon interest rate on the outstanding balance that is tied to a specific benchmark rate and is reset periodically based on the changing benchmark.
Investing in ARM securities rather than fixed-rate MBS gives Capstead Mortgage two advantages in a rising interest rate environment.
First, as interest rates rise due to speculation about the Fed ending its QE program, the interest rates on ARM securities held by Capstead Mortgage will automatically adjust upwards to more current interest rates within a relatively short period of time. On the contrary, agency mREITs that invest mostly in fixed rate securities would have to sell those securities, possibly at a loss, in order to invest in newly originated high yield securities.
Secondly, ARM securities are less sensitive to price changes as compared to fixed-rate MBS. Thus as interest rates rise, Capstead Mortgage’s book value per share would not suffer a steep drop. The same cannot be said about American Capital Agency Corp. (NASDAQ:AGNC) and ARMOUR Residential REIT, Inc. (NYSE:ARR) that invest mostly in fixed-rate long duration 30-year MBS.
What happened in the first-quarter?
In its first-quarter earnings results, Capstead Mortgage reported that its interest margin increased by 2 basis points from the previous quarter to 1.15%. Moreover, Capstead Mortgage was one of the few mREITs that reported a stable book value per share which increased by $0.02 to $13.60.
On the other hand, American Capital Agency Corp. (NASDAQ:AGNC) reported that its net interest margin decline 11 basis points sequentially to 1.52% in the first-quarter. At the same time, the mREIT felt the full force of a spike in interest rates as its book value per share dropped by 8.5% to $28.93. This is because American Capital Agency Corp. (NASDAQ:AGNC) was heavily exposed to long duration fixed-rate 30% MBS. Furthermore, American Capital Agency Corp. (NASDAQ:AGNC) had invested in MBS with low prepayment risk, and prices of these securities suffer the most as interest rates rise.
ARMOUR Residential REIT, Inc. (NYSE:ARR) also suffered a similar fate as American Capital Agency Corp. (NASDAQ:AGNC). In its first-quarter results, ARMOUR Residential REIT, Inc. (NYSE:ARR) reported that its net interest margin dropped 20 basis points from the previous quarter to 1.35%. At the same time, its book value per share dropped to $6.69 from $7.29 in the previous quarter, a decline of 8.2%.
As you can see, comparing Capstead Mortgages’ first-quarter results to those of its competitors supports my thesis that this mREIT is the right choice in an uncertain and rising interest rate environment that we are in at this time.
Foolish bottom line
A lot of the mREITS look very attractive right now based on their historical dividend yields. However, it is important to understand the risks when investing in mREITs that have invested in long duration fixed rate securities in a rising interest rate environment. With a dividend yield of 10%, I believe that the conservatively positioned Capstead Mortgage is the safest mREIT to be in right now for dividend investing as well as capital preservation due to its strategy of investing almost exclusively in ARM securities and operating at a moderate leverage level.
The article This Is The Safest mREIT To Invest In Right Now originally appeared on Fool.com.
Zain Zafar has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Zain is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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