Annaly Capital Management, Inc. (NLY), Two Harbors Investment Corp (TWO): Buy These mREITs Around QE Unwinding

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The confusion around the unwinding of QE persists as the Fed again links its unwinding intentions to macroeconomic improvements. The macroeconomic indicators continue to give mixed signals, and the mortgage REITs sector continues to be the victim of this confusion. Within mortgage REITs, the ones that invest exclusively in the Agency space are being hit the hardest. However, hybrids continue to remain the top picks of most analysts. Let’s see why.

The Agency space hit hard

The Agency mortgage REITs have become the victims of the prevailing confusion related to the unwinding of QE3. The June FOMC meeting resulted in increased interest rate volatility as the Agency MBS spread increased another 8 bps to reach its 20-month high of 3.29%.

Annaly Capital Management, Inc. (NYSE:NLY)

As a result, American Capital Agency moved down 4.3% in one day, while Annaly Capital Management, Inc. (NYSE:NLY) and ARMOUR Residential REIT, Inc. (NYSE:ARR) fell 3.4% each. Both American Capital Agency and Annaly Capital Management were also forced to cut their second quarter dividends by 16% and 11%, respectively. In contrast, ARMOUR Residential announced that it will maintain its dividends for the third quarter of the current year. Both American Capital Agency and ARMOUR Residential have been downgraded by Barclays on lower earnings potential and concerns about their book values.

So, the Agency space is under tremendous pressure. Even the largest and the most well managed mREITs are feeling the heat. Looking at this, Barclays has downgraded most of the mREITs with significant exposure to Agency MBS.

Hybrids still preferred

Given the volatility in the Agency space, mortgage REITs that invest in both Agency and non-Agency MBS are the most preferred. Better known as hybrid mortgage REITs, these offer better risk-return opportunities. Within hybrid mREITs, Two Harbors Investment Corp (NYSE:TWO) remains the top pick of Credit Suisse, Barclays and Deutsche Bank. Let’s see what makes this hybrid mREIT the favorite.

In a recent presentation, Two Harbors Investment Corp (NYSE:TWO)’ management disclosed that its book value essentially remained unchanged from the March 31, 2013 level. That’s a very positive sign for the company’s investors, particularly when none of the mREITs has been able to secure its book value. Going forward, the company is expected to benefit from its new investments, which include the newly acquired rights of mortgage servicing (MSRs) and the increase in credit sensitive loans.

The increased presence of credit sensitive loans was the primary reason why Two Harbors Investment Corp (NYSE:TWO) was able to maintain its book value during the current quarter. These loans and the other non-Agency assets that Two Harbors holds are less sensitive to changes in interest rates. Typically, credit sensitive assets increase in price due to lower default risk, which in turn is driven by a stronger economy. Given the rise in rates and the anticipated strength in the economy, credit sensitive assets tend to perform well.

On the other hand, MSRs create a two-fold benefits for Two Harbors Investment Corp (NYSE:TWO). First, they act as an interest rate hedge, which protects the book value. Second, they provide the company with the much-desired additional return. And that’s not all: The presence of significant barriers into the MSR market further creates a competitive advantage for Two Harbors in the market.

Western Asset Mortgage Capital Corp (NYSE:WMC) is another hybrid mREIT that invests in Agency and non-Agency MBS. It has other investments in commercial MBS that provide the company with elevated asset yield and diversification. The company declared its second quarter dividend of $0.9 per share, down 5% from the prior quarter’s dividend distribution. With the new reduced dividend rate, the stock is currently yielding 20.8%, higher than most of its peers. After a careful analysis of the company’s earnings potential, Deutsche Bank rated the stock as a buy.

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