Dear Valued Visitor,

We have noticed that you are using an ad blocker software.

Although advertisements on the web pages may degrade your experience, our business certainly depends on them and we can only keep providing you high-quality research based articles as long as we can display ads on our pages.

To view this article, you can disable your ad blocker and refresh this page or simply login.

We only allow registered users to use ad blockers. You can sign up for free by clicking here or you can login if you are already a member.

Annaly Capital Management, Inc. (NLY), American Capital Agency Corp. (AGNC): The Death Of QE And Its Effects On Agency mREITs

Page 1 of 2

Agency mortgage REITs are trusts that invest in mortgage backed securities that are backed by the government. This is why Agency MBS are considered to have minimal default risk. However, they are still exposed to changes in the interest rate. Therefore, the Fed’s monetary policy has significant impact on the sectors profitability.

While there is no consensus on the timing of the end of the third round of easing, there is agreement that one sector will benefit from the easing halt. mREITs have suffered a great deal at the hands of the Fed’s easing, and I believe they will be the biggest winners of a halt in easing.

In order to understand how a halt in easing will affect Agency mREITs, we need answers to the following questions:

1). What will be the impact of Fed’s tapering off of QE3 on the general interest rates and the yield curve?

2). What will be the impact of the changes in yield curve on different mREITs individually?

Changes in the yield curve

Currently, the Fed is buying bonds worth $85 billion each month with the intention of bringing down the long-term interest rates. The Fed believes this will stimulate the US economy, particularly the US housing and labor markets. The result of this easing was a flattened yield curve.

Now when the Fed finally decides to exit, the rates will start climbing, making the yield curve steeper again. These changes will only take place farther out on the yield curve and you can expect the short end of the curve to remain relatively stable, since the Fed has promised to keep the Fed Fund rate between zero-0.25%.

To understand how the steepening of the yield curve will be in the interest of Agency mREITs, we need to determine its affect on the book value and the net interest rate spreads of Agency mREITs.

Book value fluctuations

Annaly Capital Management, Inc.Fluctuations in the book values are inversely proportional to changes in the interest rates, as is true for the prices of bonds. Mortgage backed securities are bonds, and their prices move in the opposite direction to the changes in the interest rates.

As noted above, the Fed’s exit would tend to increase the long-term rates, causing the yield curve to steepen. When the rates go up, you should expect the book values to come down. mREITs with greater proportions of fixed rate Agency MBS in their investment portfolio would get hit the most. Annaly Capital Management, Inc. (NYSE:NLY)American Capital Agency Corp. (NASDAQ:AGNC) and ARMOUR Residential REIT, Inc. (NYSE:ARR) are among pure-play mREITs that are exclusively invested in fixed rate Agency residential MBS.

In contrast, the book values of mREITs with greater proportion of adjustable-rate securities in their portfolio will be less sensitive to changes in interest rates.

Variations in spreads

As the long-term rates increase and the yield curve steepens, you should expect Agency mREITs to report an expansion in their spreads. This is because they earn yield on long-term mortgage rates and pay cost on their short-term repo rates. As the yield on its MBS increases, the cost of funds stays the same as the Fed keeps them at their lowest. This expands the spread the mortgage REITs earn.

Profitability

Higher mortgage rates also discourage refinancing, which will ultimately bring down the prepayments and amortization cost that mREITs have to bear. This coupled with a higher spread should expand the mREITs’ bottom line.

Fortunately, we already have a glimpse of how the markets would react to an anticipated cut in the QE. The first quarter of the current year was marked with rumors of a premature Fed exit. The result was that investors paid more attention to the steep decline in the book values, than the expected surge in spreads.

Here is how I expect the following mREITs to perform when the Fed halts its easing

Page 1 of 2
Loading Comments...