Mortgage real estate investment trusts (REITs) have struggled mightily since the beginning of the COVID-19 pandemic. First, they were beset with margin calls as the mortgage-backed securities market froze in the early days of the pandemic. This forced all of them to sell mortgage-backed securities at fire-sale prices in order to raise cash to meet margin calls.
After that, we saw a wave of refinancing activity, which caused all of their high-coupon bonds to pay off early. Finally, the reemergence of inflation has meant volatility in the bond market, and that inevitably works against holders of mortgage-backed securities.
That said, we are seeing early indications that suggest inflation is slowing down. While the sector is not yet out of the woods, these mortgage REITs are interesting candidates for investors who like contrarian ideas.
1. AGNC Investment buys mortgages that are guaranteed by the U.S. government
AGNC Investment (AGNC 0.56%) is a mortgage REIT that invests almost exclusively in mortgage-backed securities that are guaranteed by the U.S. government. These loans are typically guaranteed by the government-sponsored entities Fannie Mae and Freddie Mac. Mortgage lenders originate mortgages and then package them into a security, which is then sold to investors, some of whom are mortgage REITs. AGNC dabbles in securities that have special characteristics that make them unlikely to pay off early.
AGNC uses leverage (in other words, borrowed money) to turbocharge its returns. It is similar to a bank -- it borrows money at low rates over the short term and then uses that money to buy longer-term assets. As of June 30, AGNC was paying 1.26% to borrow money. It then plowed that money into an investment portfolio that pays 3.6%. The use of debt is how AGNC is able to turn a portfolio of securities paying 3.6% into a stock that has a dividend yield of 11.4%.
If the Fed is successful in its mission of bringing down inflation, it won't have to aggressively raise rates, which will wring some of the volatility out of the bond market. If we get a long period of relatively stable interest rates, agency REITs like AGNC Investment will do well. If you can get it below book value per share, it is worth a look.
2. Annaly Capital invests in mortgages that are not guaranteed by the U.S. government
Annaly Capital (NLY 0.67%) has a similar business model to AGNC Investment; it invests in mortgage-backed securities that are guaranteed by the U.S. Government, but it also has a sizable portfolio of loans that are not guaranteed by the government. These loans are riskier, but they also pay much better rates. Annaly has been one of the biggest buyers of mortgage loans that do not qualify for a guarantee. Under Dodd-Frank, the lender has to prove that the borrower has the ability to repay the loan. Many professional real estate investors are unable to meet the stringent requirements of Dodd-Frank but are perfectly creditworthy borrowers. They often mortgage their properties with these types of loans, which are called non-qualified mortgages. They usually have a substantial amount of equity in the property, which makes them less risky than they sound.
While AGNC Investment is a bet on bond market stability, Annaly is more of a bet that defaults will remain low. Right now, default rates are the lowest in 15 years. Given the strength of the labor market, defaults should remain low. Rising home prices also help performance. Annaly is a bet on reduced volatility in the bond market, along with continued strength in the labor market and housing market. Like AGNC, if you can pick it up below book value per share, it might be worth a look. At current levels, it has a dividend yield of 12.9%.