As investors dig deeper to find high yields, they're paying unjustifiably high prices for shares of high-yielding mortgage REITs. Don't make the same mistake.
Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) now trade at a 10% premium to their last reported net asset values, or tangible book value, a price that doesn't reflect declining fundamentals for the mREIT industry.
Few reasons to pay a premium
Mortgage REITs are the textbook example of a commodity business. They raise equity capital by selling shares to the public, adding heaps of borrowed money, then using the proceeds to purchase mortgage-backed securities (MBS).
Like banks, mortgage REITs are in the "spread" business, earning a profit by borrowing at low rates on the short end of the yield curve and lending at higher rates on the long end of the curve. Unlike banks, though, mREITs have few proprietary ways to earn higher returns. Well-run banks attract low-cost deposits and pick good borrowers. Mortgage REITs do not have this funding cost advantage, nor do mREITs have many advantages when it comes to investment selection.
Virtually all of American Capital Agency's portfolio is invested in agency-backed MBSes, whereas Annaly has about 78% of its capital deployed in agency securities. Agency-backed paper is backed by Fannie Mae or Freddie Mac, mortgage guarantors that are themselves backed by the U.S. government. Therefore, agency-backed mortgages are said to be as safe as U.S. Treasuries.
For mREITs, this means the primary driver of their earnings isn't credit selection (picking good borrowers) or eking out an advantage in funding costs (the rates they pay are determined by the market). Their only possible advantage for the bulk of their business comes from an mREIT's ability to forecast the direction of interest rates and allocate their portfolios to reflect their view. For this reason, it makes little sense to pay a premium to book value for mREIT shares.
One proxy for the long-term profitability of the mREIT industry is the 2-10 spread, or the difference between yields on 2-year U.S. Treasuries and 10-year U.S. Treasuries.
In simple terms, when the 2-10 spread is large, mREITs can earn more money by borrowing short and lending long. When the spread is small, mREIT earnings generally suffer, as there is only a small difference between their borrowing costs and the yield they earn on their portfolios.
Curiously, mREIT share prices have been moving higher even as the 2-10 spread has remained in place for much of the last year.
The recent decline in the 2-10 spread is the consequence of Fed rate hikes. The Fed has increased its targeted short-term interest rate, but long-term rates have not increased in kind. Thus, the price mREITs pay to borrow money has gone up, but the yield they earn on their portfolios has not increased to a similar degree, resulting in lower spreads when mREITs deploy capital to buy mortgage securities.
Investors shouldn't get greedy
It's tough out there for yield investors. Super-safe, short-term investments yield little more than 2% per year. Junk bonds yield less than 5%. Thus, the double-digit dividend yields offered by Annaly Capital and American Capital Agency are tempting. But investors should be cognizant of the risk that comes with paying a premium to book value to get a double-digit dividend yield.
It was only 18 months ago that these two mREITs traded at 20% discounts to book value. Since that time, the 2-10 spread has compressed, yet mREITs now trade at a 10% premium to book value. It's inexplicable. A proxy for the industry's earnings power points downward, but share prices have rocketed higher.
It's telling that the largest mREITs haven't used their premium share prices to raise capital, which suggests that their investment opportunities are so unattractive that raising new capital to invest today would dilute their earnings on a per-share basis. Historically, mREITs have been eager to sell more shares at even single-digit premiums to book value. Of course, when mREITs were most aggressive in issuing new shares, the 2-10 spread was much higher than it is now.
It's my view that investors who wait for a fat pitch will get the chance to buy in at book value, or even less, before missing out on a full year of dividends. Patience should be rewarded with the avoidance of capital losses, if not outsized profits.
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