mREITS make their living by borrowing money at low, short-term interest rates and then buying government-guaranteed mortgage bonds that pay higher, long-term rates. They earn money on the “spread” between those two rates. They’re basically a form of a bank, only without branches, bankers, and bank commissions. As of late, shares of companies in the mREIT sector such as Annaly Capital Management, Inc. (NYSE:NLY), American Capital Agency (NASDAQ:AGNC) and Invesco Mortgage Capital Inc (NYSE:IVR), have fallen dramatically. Let’s try and figure out whether we have value investments or a value traps in our hands.
The spread is their friend
As I mentioned earlier, mREITs make money from the spread between short-term and long-term interest rates. The higher the spread – the better. Historically, yield curves flatten out prior to the economy going into recession. They may even invert, as did happen in 2006-07 and again during the Great Recession. I don’t believe we are heading into a recession. While the U.S. economic recovery has been tepid, and I agree it may accelerate soon, I question the premise that we are heading into another downturn. Indeed, if the Fed gets even a whiff of recession, the “tapering” argument gets blown out.
On the other hand, if the Fed does begin to reduce its willingness to buy up long-treasuries, conventional wisdom says this action will tend to push such securities’ yields higher, not lower. At that same time, the Fed (which has considerably more control over short-term rates) could act to maintain these low rates. Over time, such a stance would widen the spread, not diminish it.
The only problem with a sudden spike in interest rates is that when interest rates rise, the value of the existing mortgage bonds Annaly Capital Management, Inc. (NYSE:NLY) and other mREITs hold falls. That’s why investors have pushed Annaly’s share price down 18% over the last two months. American Capital Agency Corp. (NASDAQ:AGNC) and Invesco Mortgage Capital Inc (NYSE:IVR) followed the same path with a downfall of 21% and 15%, respectively. In other words, there’s currently a heavy short- term pressure on book value because of the spike in rates. And that’s exactly where our opportunity lies. We know that, in time, higher rates bring with them a higher spread. Higher spread spells more profits for mREITs. It’s a win – win.