As a result of recent volatility and spreads widening, mortgage REITs are in for a second consecutive quarter bloodbath as far as their book values are concerned. Although the stocks seem to have already priced this in, further decline in the book values cannot be ruled out. There is an upside for the book values if interest rates fall in the near term. However, that’s highly unlikely. Given the highly unlikely fall in rates, Barclays is bearish on American Capital Agency Corp. (NASDAQ:AGNC). Let’s see why.
Why rates will increase further
Regardless of the timings of the Fed’s exit, I believe interest rates will increase further. Yield on the 10-year treasury is still well below the historical norms, so rates have more room to rise than fall.
This further increase will hurt the mortgage REIT sector by creating more downward pressure on book values. When rates rise, MBS durations extend, which results in book value erosion if not adequately hedged with negative duration. This hedging also comes at a cost that lowers earnings.
Therefore, caution must be exercised when making an investment in mortgage REITs.
Why book values are critical
Now, you might be wondering if higher interest rates mean wider spreads for mortgage REITs and improved dividend prospects. So, why bother so much about the book values? That’s because mortgage REITs trade more on book value than on dividend yield. Eroding book values should have a significant impact on investors’ total returns. Should the book values fall another 10%, you can expect single digit returns from your mREIT investments.
Therefore, protecting book value is critical for mREITs right now.
Concerns of another book value decline
American Capital Agency Corp. (NASDAQ:AGNC) announced that it has already suffered a book value decline similar to the one experienced during the first quarter. Barclays has recently downgraded American Capital Agency to equal weight on concerns of a further decline in the company’s book value despite the recent portfolio rebalancing actions taken by the management. Analysts at Barclays believe that a near-term rally in interest rates could yield upside to the company’s book value. However, the probability of future book value declines overshadows any near-term positive effects.
Another negative conclusion that can be drawn from the recent actions taken by the company’s management is that increased hedging and the reduction in long-term MBS holdings will hurt the company’s earnings potential. That’s why American Capital Agency Corp. (NASDAQ:AGNC) announced a dividend cut of 16.6%. With the new dividend rate in place, the stock is still offering 16.6% yield, much higher than many of its peers.