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.
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.