Mortgage REITs have been income-oriented investors’ favorite for long due to their elevated dividend yields. Since we are well into the earnings season, I thought it’s best to write about what investors should expect from their favorite mREIT when it discloses its second-quarter performance. But before that, we will look at the performance of the MBS markets, which have a direct impact on the mREITs business.
During the second quarter, mortgage rates continued to climb on fears that the Federal Reserve might end its third round of quantitative easing sooner than expected. While the Fed didn’t end its easing programs, I believe the markets have already priced in the effect.
The average 30-year mortgage rate has climbed 89 bps since the start of the second quarter, while the 15-year mortgage rate climbed 74 bps over the same time period. As a result, bond prices are under continuous pressure.
The impacts of rising rates are mixed on mREITs. While rising rates mean lower prepayments and higher spreads, they also mean decline in book values. Let’s see which mREIT would be able to capitalize on the benefits on the rising rates.
Increased hedging costs
ARMOUR Residential REIT, Inc. (NYSE:ARR) is a pure-play mortgage REIT that invests largely in the fixed rate Agency paper. Since it has large investments in the fixed rate Agency paper, it increased its hedges during the second quarter in order to hedge the decline in its book value against rising rates. This higher spread is expected to bring down the company’s net interest rate spread by as much as 9 bps over the prior quarter.
Analysts at Barclays believe that ARMOUR Residential REIT, Inc. (NYSE:ARR) would require more time to turnover its portfolio to better suit the current rising interest rates environment. Since around 64% of the company’s portfolio is the 30-year MBS, its book value is expected to decline by as much as 15% over the prior quarter. This means, the negatives of rising rates will be more prominent when ARMOUR Residential REIT, Inc. (NYSE:ARR) reports its second-quarter performance.
Like agency mREITs?
Javelin Mortgage Investment Corp (NYSE:JMI) is the sister of ARMOUR Residential REIT, Inc. (NYSE:ARR). However, Javelin Mortgage Investment Corp (NYSE:JMI) is a hybrid mREIT. Despite being classified as a hybrid mREIT, it is not one of my most preferred hybrid mREITs. Javelin Mortgage Investment Corp (NYSE:JMI) would experience mixed effects of the rising interest rates as the company is poised to expand its net interest rate spread and should earn mid-teens return on equity (ROE) for the remainder of the year.
On the negative side, the company is expected to report as much as 13% decline in its book value as it has a large concentration in the lower coupon longer duration Agency MBS. Javelin Mortgage Investment Corp (NYSE:JMI)’s portfolio is more like an Agency mREITs’, because around 90% of its portfolio is composed of the most rate sensitive Agency security. So, it means, the negatives stemming from rising rates are poised to overshadow the expansion in the spread.
Most preferred mREIT
Two Harbors Investment Corp (NYSE:TWO) is another hybrid mREIT, and it happens to be my most preferred mREIT under the prevailing challenging situation. The company has investments in Agency and non-Agency MBS. It also has credit sensitive assets and mortgage servicing rights (MSRs), which provide a cushion to the decline in its book value. Analysts at Barclays believe that it can report a spread expansion of up to 8 bps, driven by higher return from its credit-sensitive assets.
Further, the MSRs provide an attractive investment opportunity as they act as a hedge against rising rates and provide incremental income. Given the situation, Two Harbors Investment Corp (NYSE:TWO) is expected to report the lowest book value decline of 2.5% among the entire mortgage REITs sector. So for Two Harbors Investment Corp (NYSE:TWO), I believe the positives stemming from rising interest rates will hold more importance.
Given the challenges presented by the macro economy, some mREITs are positioned to capitalize on the benefits offered by the prevailing rising rates. For others, the negatives will be more prominent. Two Harbors Investment Corp (NYSE:TWO) is one mREIT which is positioned to benefit from the current situation. On the other hand, ARMOUR Residential REIT, Inc. (NYSE:ARR) and Javelin Mortgage Investment Corp (NYSE:JMI) are expected to report significant book value declines. So, I recommend investors buy Two Harbors.
The article What to Expect From Your mREIT originally appeared on Fool.com and is written by Adnan Khan.
Adnan Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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