Yellen Crushes Mortgage REITs With Three Little Words

The specter of a hike in short-term rates rattles the sector

Mar 22, 2014 at 9:00AM

Crushed
Source: Flickr / ukhomeoffice.

The press conference following the Federal Reserve's meeting on Wednesday spurred markets to react quickly, punishing mortgage REITs. Down went shares of Annaly Capital Management, (NYSE:NLY), American Capital Agency Corp. (NASDAQ:AGNC) and CYS Investments (NYSE:CYS), heavies in the agency-backed mortgage bond investment sector. Annaly and American Capital Agency dropped by more than 2.25%, while CYS dipped more than 3%.

What caused the carnage?
New chair Janet Yellen's debut as the mouthpiece of the Federal Reserve will likely be remembered for the three-word phrase, "around six months". This was her answer to a question regarding the timeline the Fed might follow in raising short-term interest rates after its bond-buying program ends.

Math whizzes everywhere instantly came up with an answer: at the current decreases of bond and mortgage-backed security purchases of $10 billion per month, the taper would produce an end to the Fed's easy money policy by October. This could mean that the federal funds rate, currently at 0% to 0.25%, would begin to rise around this time next year.

Staying the course
This shouldn't have been unexpected. The Fed appears to be carrying on with its slow and easy accommodation-tapering schedule, taking economic indicators like unemployment and inflation into consideration as it continues to massage monetary policy. In fact, the committee scrapped its prior unemployment target rate of less than 6.5% to begin raising short-term rates, noting that, despite labor market improvements, the unemployment rate is still high.

And, with the now-accepted tapering rate of $10 billion per month in bond purchases, the end of QE3 is right on track. The big issue, particularly for mREITs, is the perception of a timeline that would produce a hike in short-term interest rates.

As the Wall Street Journal's Jon Hilsenrath notes, committee members presently seem to be leaning more toward short-term rates sitting at 2% or more by the end of 2016, with 12 of 16 now holding that opinion. Last December, only eight members envisioned a 2% rate by December 2016.

More pain ahead for mREITs
Will the turmoil in the mREIT sector soon run its course, now that investors have a better idea of what the Fed is planning? Perhaps – uncertainty has caused a lot of trouble for mREITs over the past year, as investors fretted over the commencement of the taper. Once it began, though, things settled down pretty quickly.

This time, however, the short-term rate hike issue has reared its ugly head, as well. Rising long-term rates are problematic for mortgage REITs, reducing the value of legacy assets – and, therefore, book value.

But an uptick in the short-term rate will increase borrowing costs, a real worry for these trusts, and their investors. After five years of ultra-low short-term interest rates, the sector now has approximately one year to plan for a rise in the benchmark rate. Sharp-eyed investors, no doubt, will be watching them every step of the way.

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Amanda Alix 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.

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