American Capital Agency Corp. (AGNC), ARMOUR Residential REIT, Inc. (ARR), Annaly Capital Management, Inc. (NLY): Two mREITs To Buy, One To Avoid

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Mortgage REITs have remained a favorite investment vehicle for many investors’ for a very long time due to their elevated (double digit) dividend yields. Some of the most-followed REITs offer dividend yields in excess of 17%, while 10-year Treasuries are only offering 1.92%. However, these elevated dividend returns are not without elevated risk.

mREITs have a complex business model. It is a model in which the management does not have complete control over the company’s revenues. This is because its revenues are highly linked to the country’s macroeconomic environment, particularly the housing and mortgage markets.

The bond buying and its endeavors?

One of the major catalysts that are currently in play for mREITs is the Fed’s accelerated bond buying. The Fed has initiated an accelerated bond buying with an intention to stimulate the sluggish US economy, particularly the US housing and the labor markets. While the stimulus efforts are still delivering their results, profits at mortgage REITs are being crushed because of it.

The Fed is buying $40 worth of residential mortgage backed securities every month. These are the RMBS for which any of the government Agencies has guaranteed the principal and interest payments. The aim of this bond buying was to bring down the long-term mortgage rates in order to encourage refinancing and mortgage originations. However, one downside of this bond buying program is that lower long-term mortgage rates mean lower revenues for the Agency mortgage REITs.

How mREITs earn money?

Mortgage REITs own and invest in mortgage backed securities and earn an asset yield that is directly linked to the prevailing mortgage rates. Mortgage REITs finance their MBS portfolios using short-term repurchase agreements and pay a cost of fund on them. Finally, mortgage REITs earn a “spread” over what they pay on their interest bearing liabilities and what they earn on their interest yielding assets.

Little control over profits

Annaly Capital Management, Inc.So, the mortgage REITs earn a spread which is directly being compressed by the Fed’s bond buying programs, and managements at some of the largest mortgage REITs have little options to maintain their spreads. The effects of the Fed’s stimulus are more evident in the second quarter; the average 30-year fixed mortgage rate has gone down 6 bps, while the average 15-year fixed rate plunged 7 bps since the start of the second quarter. This is why mortgage REITs, including American Capital Agency Corp. (NASDAQ:AGNC) ARMOUR Residential REIT, Inc. (NYSE:ARR) and Annaly Capital Management, Inc. (NYSE:NLY) have been lit up bright red for the past few days.

However, prices of some of the most-followed mREITs bounced back yesterday after a string of weak economic data. The weak economic data led to a big drop in the Treasury yields yesterday as the 10-year Treasury fell 6 bps to 1.88%. As a result, Annaly Capital Management, Inc. (NYSE:NLY) and ARMOUR Residential REIT, Inc. (NYSE:ARR) experienced 1.9% and 2.6% increases in their respective stock prices, while Western Asset Mortgage led the recent rally as its shares surged 3.3%.

This makes in abundantly clear that management has little control over the profits and the stock price. Therefore, investors looking to invest should look for the following positive business drivers.

Annaly Capital Management, Inc. (NYSE:NLY)

Annaly Capital Management, Inc. (NYSE:NLY) happens to be the largest mortgage REIT in the US. The company has seen little appreciation in its stock price since the beginning of the year as its YTD is 5.8%. However, the stock price fell 7% since the start of the second quarter.

I believe decreased funding costs along with the MBS sold during the first quarter will allow Annaly Capital Management, Inc. (NYSE:NLY) to report higher spreads compared to the first quarter. Besides, the recent acquisition of CreXus Investments will increase Annaly’s average yield in the coming quarter. You can also expect a book value growth if prepayments remain moderate.

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