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Annaly Capital Management, Inc. (NLY), American Capital Mortgage Investment Crp (MTGE) – Agency mREITs: Is a Bottom in Sight?

I am positive on the mortgage REITs sector following their dramatic sell-off. The MBS spreads are back to their pre-QE3 levels, and the stocks are trading below their book values. Also, I believe the unwinding of the QE is already priced into the mortgages. Therefore, volatility is expected to subside, and the supply-demand imbalance will improve in the second half of the current year. Given the expectations, I recommend investors start adding their favorite mREITs to their portfolio.

Annaly Capital Management, Inc. (NYSE:NLY)

A view of the mREIT space

The near-term macro backdrop is positive for the mREITs. UBS AG (ADR) (NYSE:UBS) economist Maury Harris forecasts that the Fed will begin tapering QE3 in 4Q13 with a complete halt to the asset purchases by the mid of 2014.

His positive views on the mREITs space are supported by the following:

Since the start of the QE3, Agency MBS spreads have reversed all their gains. As a result, the QE3’s impact has been priced out even though Agency MBS purchases are still expected to continue through December.

In dollar terms, the prices of Agency MBS bonds with coupon payments over 3.5% are trading below their one year lows. I believe these low levels could attract investors to enter the market.

The spike in mortgage rates has caused the MBS refinance index to plunge over the past few weeks. As a result, you should expect slow MBS issuance in the second half of the current year, making the supply-demand imbalance more favorable. Looking at the favorable situation, UBS analysts believe the mREITs’ book values are better positioned to rise than to fall over the next several months.

Funding risk not significantly reduced

UBS AG (ADR) (NYSE:UBS) analysts believe liquidity is among the biggest risks to Agency mortgage REITs. That’s because the mREITs use a lot of leverage in their business models, which magnifies their results on both sides.

The majority of the Agency mREITs’ funding has to be rolled every 30 days. Agency mREITs have been seen increasing their funding maturities in recent quarters. Annaly Capital Management, Inc. (NYSE:NLY) increased its duration to 220 days from the fourth quarter’s 197 days. In comparison, American Capital Mortgage Investment Crp (NASDAQ:MTGE) increased its funding maturity by 21 days to 108 days. American Capital Agency Corp. (NASDAQ:AGNC) extended the maturity of its interest bearing liabilities by only 2 days to 183 days.

The extension in the maturities of funding reduces the risk of short-term funding, while it also has the effect of compressing the spread further. Increased maturities mean higher cost of funds on these longer-term liabilities. Therefore, it’s clear that American Capital Mortgage Investment Crp (NASDAQ:MTGE)’s investors should expect higher cost of funds during the current quarter because it extended its funding maturity the most.

The bottom line is that funding portfolio duration has trended up while leverage has trended down. However, this lower level of leverage has not significantly reduced liquidity risk for the mREITs’ business model.

The sister companies

The sister mREITs, American Capital Agency Corp. (NASDAQ:AGNC) and American Capital Mortgage Investment Crp (NASDAQ:MTGE), have about 30% of their asset portfolios invested in the 15-year fixed rate security, which has held up better in value relative to the 30-year fixed rate security, some of which American Capital Agency Corp. (NASDAQ:AGNC) has recently gotten rid of.

American Capital Agency Corp. (NASDAQ:AGNC) is expected to report lower earnings due to its latest portfolio rebalancing efforts and its commitment to actively manage its assets and hedges. The reduction of the 30-year fixed high yielding security would mean fewer earnings, while active management of hedges and assets would mean higher costs in the current quarter.

However, both are largely in the specified pool MBS, which offer better sensitivity with changes in interest rates. American Capital Mortgage Investment Crp (NASDAQ:MTGE) has a higher percentage of current coupon TBA and, therefore, will likely see a greater decrease in its book value during the current quarter.

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