The COVID-19 pandemic has been downright awful for the mortgage real estate investment trust (mREIT) sector. In the early days of the pandemic, liquidity in the mortgage market dried up and the companies were beset with margin calls. This forced them to shrink their portfolios and cut their dividends. Once interest rates were cut to zero, a refinancing wave caused their portfolios to pay off early, costing them years of expected income. Finally, the increase in rates since the beginning of the year has driven book values lower.
At long last, the sector might be getting a more favorable environment. Interested in double-digit dividend yields? Then pay attention to the mortgage REIT sector.
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Mortgage REITs have a different business model
Mortgage REITs like AGNC Investment (AGNC 1.85%) have a different business model from most REITs. Most REITs invest in properties and follow a landlord/tenant model. They develop properties and finance them with long-term debt. They then lease out the properties and earn a spread between their rent and their interest cost. It is a relatively easy-to-understand approach.
Mortgage REITs don't invest in properties, however -- they invest in real estate debt, i.e., mortgages. AGNC specializes in mortgages that are guaranteed by the U.S. government. If you recently bought a house and took out a mortgage, chances are it was guaranteed by Fannie Mae or Freddie Mac and then securitized into a mortgage-backed security. AGNC specializes in these securities.
The Fed has been a headwind, but will be less of an issue going forward
The mortgage REIT market has taken a beating as interest rates have risen amid fears that the Federal Reserve will begin to sell off its holdings of mortgage-backed securities that it has bought since quantitative easing began in 2008 or so. It currently holds about $2.7 trillion worth of mortgages, or over 100% of 2022's expected mortgage production. This expected supply has weighed on the sector.
Mortgage-backed securities are highly sensitive to interest rate volatility. In other words, when rates are all over the place, mortgage-backed securities tend to be unattractive relative to Treasuries. Mortgage-backed securities contain the same amount of credit risk as Treasuries (i.e., no credit risk), but they pay higher returns. This extra return isn't "free" -- it represents the additional sensitivity to interest rates. When rates rise, mortgage-backed securities fall faster than Treasuries. When rates fall, they underperform Treasuries. This is because borrowers can always pay off their mortgage early. To compensate for that risk, mortgage-backed securities pay higher yields. Mortgage REITs like AGNC Investment are experts in managing that risk (called convexity risk).
Mortgage-backed securities are the most attractive they have been in years
As the Fed has hiked the federal funds rate, the yield curve (the difference between long-term and short-term interest rates) has inverted. This means short-term interest rates are higher than long-term rates. While inversion often is a recessionary signal, and it also seems to indicate that longer-term interest rates have stabilized. This is good news for mortgage-backed securities investors like AGNC Investment.
For AGNC, the potential returns on its portfolio are quite attractive. The yields that mortgage-backed securities earn versus Treasuries, or the spread, are the most attractive they have been in years. This means that earnings should be rising, all things being equal. As the Federal Reserve winds up its rate hikes by the end of the year, a big cloud over AGNC's head should go away. The end of the hiking cycle should damp interest rate volatility in general, which means mortgage-backed securities should outperform Treasuries.
Mortgage REITs aren't a buy yet, but they should be looked at in late 2022 or early 2023
Mortgage REITs pay unusually large dividend yields. At current levels, AGNC's stock yields 13.1%. Mortgage REITs aren't for the faint of heart, as they are highly susceptible to financial upheaval. That said, the market environment for the sector has been terrible since the pandemic began. The outlook is beginning to brighten. Investors should start looking at the sector now, with an eye toward buying late in the year as the Fed wraps up its tightening cycle. Mortgage REITs aren't a buy yet (definitely wait for Q3 earnings), but they should be on an income investor's radar screen.
