The sharp move higher in interest rates post the Federal Open Market Committee meeting presented a tough week for most mortgage REITs’ book value and stocks including Annaly Capital Management, Inc. (NYSE:NLY) and Capstead Mortgage Corporation (NYSE:CMO). Therefore, I continue to favor hybrids over the entire agency space. However, just like Two Harbors Investment Corp (NYSE:TWO), the aforementioned agency-only names present some potential for better book value preservation in the face of rising interest rates.
Book value risk
In a recent research note on mortgage REITs, Credit Suisse states that estimating book value presents more of a challenge in the current environment than usual given the magnitude of moves in mortgage and interest rates. Mortgage REITs have de-risked as rates have increased, but the timing and magnitude of the timing is not known yet.
Duration extension risk
During the second quarter, the 30-year MBS durations have extended by 0.7-2.0 years, given the 70 bps increase in rates. Credit Suisse expects another 50 bps move in the rates would cause a further extension, although at a slower pace. The duration extension is a key reason why mortgage REITs require the need to reduce the duration by selling or by extending the duration of liabilities through additional swaps.
Valuations
On average, the mortgage REITs are trading at a 10% discount to the book values estimated by Credit Suisse. While the sector is viewed as cheap relative to book value, it’s still considered too soon to start buying the sector until some stability in the rates is seen, which would lead to some book value stability.
With regards to its first-quarter book value, Annaly Capital Management, Inc. (NYSE:NLY) is trading at a 16% discount. Credit Suisse estimates a book value of $13 for the company, which means it’s trading at 2.7% discount to its estimated book value.
Similarly, Credit Suisse estimates a book value of $23.72 for American Capital Agency Corp. (NASDAQ:AGNC), which means it’s trading at 3.8% discount. ARMOUR Residential REIT, Inc. (NYSE:ARR) is trading at 14.5% discount to its estimated book value. Therefore, within the largely followed Agency players, ARMOUR Residential REIT, Inc. (NYSE:ARR) is trading at a discount larger than the entire market.
Annaly Capital not out
Annaly Capital Management, Inc. (NYSE:NLY) utilizes less leverage that most of its peers in the Agency mREIT space, and thus, declines in its book value should likely be lower than the group average. Barclays, in its research note, expects Annaly Capital Management, Inc. (NYSE:NLY) to still generate 9%-10% return on equity, which is less than the peer group average.
The company is expected to benefit from lower compensation expense due to the externalization of its management structure. Besides, the presence of CRE loans and additional return available from its recent CreXus Investment acquisition will lead the company to preserve its book value and provide support to the book value.
Portfolio rebalancing is the key for this mREIT
American Capital Agency Corp. (NASDAQ:AGNC) is another well-managed agency-only mREIT. The company experienced around 9% decline in its book value, and a similar decline had already occurred when it presented at the Morgan Stanley (NYSE:MS) investor conference.
