During the second quarter, we saw mortgage REITs nosedive on fears of significant book value declines due to the expected slowdown in the Federal Reserve’s stimulus and the resultant rising interest rates. Given the situation, some analysts recommended investors buy hybrids as their book values were expected to report lower declines compared to Agency-only mREITs. A couple of hybrids have reported their performances for the second quarter. Let’s see whether these hybrids were able to outperform their Agency-only counterparts during the quarter as expected or not.
Rising rates cause net interest spreads to widen and the book values to decline, while prepayments slowdown. So, these three metrics will be analyzed in the article.
Hybrid vs. Agency-only
Before comparing the performances of Agency and hybrid mREITs, you should be clear about their differences. So, for those of you who are not, Agency mREITs invest in MBS that are issued and guaranteed by the U.S. government Agencies only. Hybrid mREITs invest in Agency and non-Agency (also known as private-label) MBS. Since non-Agency MBS don’t have government backing, they expose mREITs to default risk. To offset this risk, they offer higher returns compared to Agency MBS.
Why hybrids were preferred?
Under QE3, the Fed has committed itself to buying Agency MBS with certain attributes in order to keep the mortgage rates low. This created downward pressure on Agency MBS prices. As a result, the mREITs that owned these MBS were expected to face significant book value declines. As a result, hybrids that invested in assets other than Agency MBS were expected to outperform their Agency-only counterparts. Let’s see whether that actually happened or not.
Hatteras Financial Corp. (NYSE:HTS) is primarily invested in Agency residential MBS that are backed with single-family loans. These Agency securities are both fixed-rate and adjustable-rate mortgage (ARMs). So, the company can be classified as an Agency-only mREIT. At the end of the second quarter, it reported EPS of $0.60, $0.04 per share behind the consensus mean estimate.
This is not the only disappointment. Since, Hatteras Financial Corp. (NYSE:HTS) is an Agency mREIT, it reported a 21.3% sequential decline in its book value and an 18 bps decline in its net interest spread over the same time period. Also, the prepayment speeds (measured by CPR) increased from 19% in 1Q to 20.8% at the end of the second quarter. During the same time period, the company increased its leverage from 7.4 times to 9.3 times its shareholder equity.