Rates and REITs

A few months ago, I took a statement by Charles Plosser, President of the Federal Reserve Bank of Philadelphia, as a warning flag for higher rates. Recent events have pulled that warning flag down and stuffed it in a box for an extended period.

One group that's very sensitive to rates is mortgage REITs. These companies borrow at the short end of the yield curve to leverage up and buy higher-yielding, longer-term mortgage backed securities. Because of the leverage, any increase in short-term borrowing rates would put a squeeze on the interest margins and juicy, double-digit yields they pay.

In the most recent monetary policy update, the Fed's release included the following:

The Committee continues to anticipate that economic conditions -- including low rates of resource utilization and a subdued outlook for inflation over the medium run -- are likely to warrant exceptionally low levels for the federal funds rate for an extended period.

The key words are "extended period." That means investors can expect near-zero short-term rates for some time. And, mortgage REITs like Annaly Capital (NYSE: NLY  ) , Hatteras Financial (NYSE: HTS  ) and Chimera Investment (NYSE: CIM  ) can expect the nice interest rate spreads to continue.

The Current Yield column in last weekend's Barron's included a survey of interest rate expectations from thirteen market pros. None of the experts surveyed predict the Fed Funds rate will increase before the end of the year and seven of the 13 see that rate holding steady through June of next year. All of the crystal balls see higher rates on the 10-year Treasury, a common benchmark for mortgage rates, over the next year.

Modest increases in mortgage rates are a mixed bag for the mortgage REITs. Assuming short-term rates hold, the spread on new securities would increase. But, higher rates take a slice out of the value of existing paper, decreasing book value and the value of the paper used to back borrowing.

Investors who want to avoid default risk of the mortgage securities held can pick from mortgage REITs that hold paper backed by government agencies Fannie Mae and Freddie Mac. REITs in this category include Annaly Capital, Hatteras Financial, and American Capital Agency (Nasdaq: AGNC  ) .

For those willing to take a little more portfolio risk to earn (hopefully) a higher yield by including non-agency backed paper in the portfolio, Chimera Investment, Two Harbors Investment (NYSE: TWO  ) , and Invesco Mortgage (NYSE: IVR  ) are among the dividend darlings.

The prospect of ultra-low short-term borrowing rates and stable to slowly increasing longer-term rates may as well be a license for mortgage REITs to continue churning out double-digit yields.

You can follow any of the stocks mentioned using our free watchlist service, My Watchlist.

Fool contributor Russ Krull owns shares Hatteras Financial, but does not have have a position in any of the other companies mentioned in this article. The Motley Fool owns shares of Chimera Investment and Annaly Capital Management. 

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Read/Post Comments (4) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 05, 2011, at 4:52 PM, mike2153 wrote:

    I like (and own) Resource Capital Corp. - RSO. Motley Fool rarey mentions it, but it's done quite well by me. It has a yield of over 15% at its current price ($1.00 / share) and it's up about 20% from I what bought it at 17 months ago, as well.

  • Report this Comment On July 05, 2011, at 7:16 PM, 1caflash wrote:

    I had RSO and NRO but sold them. (mike2153 seems Smart!) Chimera and American Capital Agency are in my DRIP. I do not know why CIM's stock price isn't doing a bit better; I think it is undervalued.

  • Report this Comment On July 06, 2011, at 12:29 PM, SgtWHood wrote:

    I've been watching REIT's for a few years now. I'm long on CIM, ANH, MFA. I've been reaping these rewards for over 2 years and couldn't be happier. I'm also a fan of comparable CEF's: CFP is my current favorite.

  • Report this Comment On July 06, 2011, at 9:44 PM, yieldmaven1 wrote:

    NLY feels a little rich. Seeking Alpha wrote an article on NLY recently... http://seekingalpha.com/article/277872-is-annaly-capital-cur...

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