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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.
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