Annaly Capital Management, Inc. (NLY), American Capital Agency Corp. (AGNC): The Death Of QE And Its Effects On Agency mREITs

Agency mortgage REITs are trusts that invest in mortgage backed securities that are backed by the government. This is why Agency MBS are considered to have minimal default risk. However, they are still exposed to changes in the interest rate. Therefore, the Fed’s monetary policy has significant impact on the sectors profitability.

While there is no consensus on the timing of the end of the third round of easing, there is agreement that one sector will benefit from the easing halt. mREITs have suffered a great deal at the hands of the Fed’s easing, and I believe they will be the biggest winners of a halt in easing.

In order to understand how a halt in easing will affect Agency mREITs, we need answers to the following questions:

1). What will be the impact of Fed’s tapering off of QE3 on the general interest rates and the yield curve?

2). What will be the impact of the changes in yield curve on different mREITs individually?

Changes in the yield curve

Currently, the Fed is buying bonds worth $85 billion each month with the intention of bringing down the long-term interest rates. The Fed believes this will stimulate the US economy, particularly the US housing and labor markets. The result of this easing was a flattened yield curve.

Now when the Fed finally decides to exit, the rates will start climbing, making the yield curve steeper again. These changes will only take place farther out on the yield curve and you can expect the short end of the curve to remain relatively stable, since the Fed has promised to keep the Fed Fund rate between zero-0.25%.

To understand how the steepening of the yield curve will be in the interest of Agency mREITs, we need to determine its affect on the book value and the net interest rate spreads of Agency mREITs.

Book value fluctuations

Annaly Capital Management, Inc.Fluctuations in the book values are inversely proportional to changes in the interest rates, as is true for the prices of bonds. Mortgage backed securities are bonds, and their prices move in the opposite direction to the changes in the interest rates.

As noted above, the Fed’s exit would tend to increase the long-term rates, causing the yield curve to steepen. When the rates go up, you should expect the book values to come down. mREITs with greater proportions of fixed rate Agency MBS in their investment portfolio would get hit the most. Annaly Capital Management, Inc. (NYSE:NLY)American Capital Agency Corp. (NASDAQ:AGNC) and ARMOUR Residential REIT, Inc. (NYSE:ARR) are among pure-play mREITs that are exclusively invested in fixed rate Agency residential MBS.

In contrast, the book values of mREITs with greater proportion of adjustable-rate securities in their portfolio will be less sensitive to changes in interest rates.

Variations in spreads

As the long-term rates increase and the yield curve steepens, you should expect Agency mREITs to report an expansion in their spreads. This is because they earn yield on long-term mortgage rates and pay cost on their short-term repo rates. As the yield on its MBS increases, the cost of funds stays the same as the Fed keeps them at their lowest. This expands the spread the mortgage REITs earn.

Profitability

Higher mortgage rates also discourage refinancing, which will ultimately bring down the prepayments and amortization cost that mREITs have to bear. This coupled with a higher spread should expand the mREITs’ bottom line.

Fortunately, we already have a glimpse of how the markets would react to an anticipated cut in the QE. The first quarter of the current year was marked with rumors of a premature Fed exit. The result was that investors paid more attention to the steep decline in the book values, than the expected surge in spreads.

Here is how I expect the following mREITs to perform when the Fed halts its easing

American Capital Agency Corp. (NASDAQ:AGNC)

American Capital Agency Corp. (NASDAQ:AGNC) is one of the largest mREIT that invests in Agency residential MBS. The company has a concentration in longer-duration fixed rate MBS with low loan balances and relatively low prepayment risk. This is why American Capital Agency Corp. (NASDAQ:AGNC) reports one of the lowest prepayments speeds for its investment portfolio.

While the company’s strategy is better in a low interest rate environment, I believe the company can experience a fall in the book value during times of rising interest rates. It was evident after the first quarter results that the company’s book value plunged over 8% after a small rise in the rates. Therefore, it appears that American Capital Agency Corp. (NASDAQ:AGNC) has positioned its portfolio in such a way that it will benefit if the QE stays intact longer than expected.

Annaly Capital Management, Inc. (NYSE:NLY)

Annaly Capital Management, Inc. (NYSE:NLY) Management also invests in fixed rate residential mortgage backed securities. It reported a 4.2% decline in its book value at the end of the first quarter. You can expect a further decline in the company’s book value as the Fed starts tapering off the QE. However, at the same time, you can expect an expansion in its net interest rate spread. According to the latest SEC filings of Annaly Capital Management, Inc. (NYSE:NLY), its projected net interest income would increase by around 17% if the rates surge 50 bps.

ARMOUR Residential REIT, Inc. (NYSE:ARR)

While ARMOUR Residential REIT, Inc. (NYSE:ARR) has some proportion of hybrid adjustable-rate securities in its portfolio besides the large concentration of fixed rate securities, it also reported an 8% decline in its book value during the first quarter. This was largely due to a higher level of leverage that ARMOUR Residential REIT, Inc. (NYSE:ARR) employs. Therefore, if the leverage remains at the same levels, you can expect the company to underperform as the Fed starts to exit bond buying.

Final Thoughts

I believe the Fed’s exit is already being priced in by the markets as the long-term rates have started climbing. Therefore, investors looking for the Fed’s eventual exit may reconsider and make their moves now. While the entire mortgage REITs sector will benefit from expansion in the spreads and low prepayment risks, you can expect Annaly Capital Management, Inc. (NYSE:NLY) to benefit the most. I believe American Capital Agency needs to reposition its portfolio, while ARMOUR Residential REIT, Inc. (NYSE:ARR) needs to de-leverage in order to handle a QE tapering.

The article The Death Of QE And Its Effects On Agency mREITs originally appeared on Fool.com and is written by Adnan Khan.

Adnan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

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