American Capital Agency Corp. (AGNC), ARMOUR Residential REIT, Inc. (ARR): What’s Wrong With This mREIT?

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American Capital Agency Corp. (NASDAQ:AGNC) has been one of the star performers in the mortgage REIT sector since its inception in 2008. However, the recent performance of this mREIT is something to worry about as the stock price has dropped rapidly over the past few weeks.

American Capital Agency Corp. (NASDAQ:AGNC)

What’s going on in the mREIT Sector?

Agency mortgage REITs like American Capital Agency Corp. (NASDAQ:AGNC) invest in long duration mortgage backed securities (MBS) that are backed by the government. They finance these investments using short-term funding from repos and make money from the spread between the higher return on their MBS investments and lower short-term borrowing costs. This spread is then levered up to magnify the returns.

In the recent past, the Fed has kept the long-term interest rates artificially low by intervening in the long-term mortgage and treasury bonds market through its quantitative easing programs. This had the effect of reducing the interest rate spread for mortgage REITs, but at the same time, inflated the prices of the securities held by these mortgage REITs, which resulted in rising book values for the sector.

However, now the market has started to anticipate that the Fed is about to end its QE program. As a result, bond yields have started to rise which has the impact of damaging the book values for the mortgage REITs.

Why the underperformance?

In its first-quarter earnings results, American Capital Agency Corp. (NASDAQ:AGNC) reported that its book value per share declined 8.6% due to rising yields on mortgage bonds. Interest rates have risen further since the results were announced and the stock has dropped more than 20% over the past three months. At the same time, the iShares FTSE NAREIT Mortgage REITs Index ETF has dropped more than 10% during this period.

American Capital Agency Corp. (NASDAQ:AGNC) has underperformed over the past few months in response to rising long-term interest rates for the very same reasons that it had outperformed its peers during the low interest rate environment: its portfolio is designed for a low interest rate environment. American Capital Agency Corp. (NASDAQ:AGNC) has paid premium prices to acquire securities with low prepayment risk such as lower loan balance HARP securities. This strategy helps American Capital Agency Corp. (NASDAQ:AGNC) against prepayments as mortgage owners pay early to refinance at lower interest rates, thus forcing mortgage REITs to reinvest in lower yielding securities.

While MBS securities with low prepayment risk were in high demand and attracted big premiums as long-term rates were falling, the attractiveness of such securities is severely reduced as prepayments and refinancing activity naturally falls when interest rates rise. As a result, these securities see a much sharper fall in value as compared to generic mortgages, treasury bonds, or interest rate swaps that are used to hedge the interest rate risk. That is why American Capital Agency is underperforming its competitors in a sector that is taking a hit from rising interest rates.

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