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American Capital Agency: QE3 Cannot Be Ignored

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By now, those who invest in mortgage real estate investment trusts know that the Federal Reserve has embarked on another round of quantitative easing. The newsiest items contained in the announcement are that the bond purchasing will concentrate on mortgage-backed securities, rather than Treasury bonds, and that the buying spree will be ongoing, month to month, until the economy perks up and takes notice. The big question is: How will this new Fed program affect mREITs?

AGNC sees risk in prepayment rates
American Capital Agency
(Nasdaq: AGNC  ) presented at the JMP Securities Services and Real Estate Conference on September 13, just hours before the Fed's announcement. The company noted the high probability that QE3 would become reality, and noted that increased MBS purchasing was likely.

Based upon this premise, the REIT's management predicted lower yields, higher MBS prices and values, and a possibility of increased refinancing due to lower long-term rates. The biggest concern, and one that affects other high-yield mREITs such as Annaly Capital (NYSE: NLY  ) , AG Mortgage Investment Trust (NYSE: MITT  ) , and Invesco Mortgage Capital (NYSE: IVR  ) is prepayment risk.

As fellow Fool John Maxfield has recently pointed out, mREITs make their money on the spread between low short-term borrowing rates and higher long-term investments. When mortgages with higher interest rates are prepaid in order to refinance into a new, lower interest rate-bearing loan, these companies find their interest spreads uncomfortably compressed. Less income means lower dividends for investors, and American Capital, along with Annaly and Invesco, have found it necessary to reduce dividend payments over the past year or so.

What are mREITs doing to protect themselves?
American Capital has stated that it has taken several steps to insure against problems caused by additional Fed action. Like others in this situation, it has decreased its prepayment risk by increasing its stable of mortgages with low loan balances, as well as newer loans refinanced under the Home Affordable Refinance Program. The company also notes that it has a number of hedges in play to protect against rising short-term interest rates.

AG Mortgage Investment, like the above REITs, primarily buys agency-backed MBSes, but is embarking upon a program to increase the number of higher-yield, non-agency mortgage bonds in its portfolio. Analysts expect the company to sell some of its agency stash and replace them with non-agency bonds as well as commercial MBS products in the near future.

One Fool's take
Successful mREITs have weathered two previous QE scenarios, in 2008 and 2010, and still remain a favorite of yield-hungry investors with their impressive returns.

Will prepayments speed up, hurting these companies over the next year or two? Time will tell, but I tend to agree with American Capital when it predicts that banks will use any leeway in that area to pad their interest margins. Also, the Fed has pushed off any increase in short-term rates until at least 2015, which means the short and long of it may actually favor, rather than negatively impact, mortgage REITs for the foreseeable future.

Investors know that Annaly is a standout in the mREIT sector and has been producing excellent returns for 30 years. To find out more about this tried-and-true income producer, access our premium report that gives you the rundown on this impressive company, complete with the risks and opportunities it faces down the road. Click here to get the full story.

Fool contributor Amanda Alix owns no shares in the companies mentioned above.

The Motley Fool owns shares of Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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