While the two companies' strong run so far in 2014 is certainly nice for current shareholders, the real questions are: How'd they manage it and is it too late to join the party?
The worst thing that can happen to mREITs is a sudden spike in mortgage rates, and that's exactly what happened around April 2013. This is because interest rates and mortgage security prices have a directly inverse relationship. So, as rates rise, it effectively lowers the value of currently held securities as those assets "reprice" to fit the current yield environment. Ultimately, it leads to lower book value, tighter earnings, and beaten down stock prices.
But so far this year, the bond market's been not only much less volatile, but interest rates have actually trended downward -- both of which create nice tailwinds.
Prepayment rates have also been historically low. Hatteras' chief operating officer, Benjamin Hough, said it best: "The lower and steadier prepayment rates being more predictable cash flows, and therefore more efficient reinvestment and better hedging results."
Hedging is used to create more consistent borrowing costs. But the key is to match the duration of assets with the duration of derivatives (hedges). It can get a bit tricky, but getting the timing right can help to avoid paying higher borrowing costs. Though, with prepayments well in hand, this process becomes more manageable.
Ultimately, some nice environmental tailwinds -- along with, perhaps, some market overreaction to events in 2013 -- helped to aid the strong run for both companies. Which is probably most evident considering an investor could have taken less risk holding a couple of the most popular mREITs and would've still earned a 18% plus total return over the last six months .
Both CYS and Hatteras use leverage (debt-to-equity) to magnify returns. The more borrowing they do the greater potential returns and losses. So, considering both companies reduced their leverage from the 7.5x range in the first quarter of 2013 to 6.3x as of the most recent quarter that could stifle returns.
Though, as CYS Investments' CEO Kevin Grant suggested in the company's first quarter conference call, "Looking forward ... with the [Federal Reserve] continuing to taper their asset purchases, we anticipate Agency mortgage-backed securities prices to cheapen later in the year and we're preparing... to take advantage." In other words, they hope to borrow more, increase leverage, and acquire assets.
Hatteras, on the other hand, mainly invests in adjustable-rate mortgages (ARMs). Considering the Federal Reserve's purchases have been in 30-year fixed-rate securities, CYS's strategy isn't likely to work for Hatteras.
On the prepayment front, Benjamin Hough noted that there was potentially some seasonality to lower prepayment rates and we'll likely see those rise moderately as the year progresses.
Rising prepayment rates may cause some issues for CYS, but for Hatteras, they believe it creates opportunity. ARMs consistently see higher prepayments than fixed-rate securities, therefore, if interest rates rise (cheapening mortgage securities) it could put the company in a strong reinvestment position.
The last word
Considering the environment isn't likely to be as friendly in the second half of 2014, I don't think we'll see another 20% plus return from either company. But for income investors looking to take on some extra risk, I think there's opportunity here.
With that said, given the choice between the two, I'm favoring Hatteras. The company has some unique pipelines for collecting its ARMs and I believe that gives it some competitive advantage. Moreover, Hatteras has suggested it may be investing in jumbo non-agency securities, which would make the company more versatile and could help generate greater asset yields moving forward.
Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.