The prospect of rising interest rates makes investors in mortgage REITs such as Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) nervous, and for good reason. Rising interest rates can quickly erode the value of mREITs' assets, as we saw when mortgage rates spiked last year.
However, the excellent preparation of these companies as well as the Federal Reserve's fear of derailing the economy's recovery should give investors some comfort. There is simply no need to get anxious and worried each and every time the Fed is about to make a statement.
Two different, but effective ways of preparing for rising rates
Annaly chose to reduce its leverage in order to be able to take advantage of opportunities. In response to the uncertain, spiky interest rates of last year, the company reduced its leverage ratio from 7-to-1 to about 5-to-1.
The company sees interest rate spreads widening over the next year or so, and wants to be able to take full advantage and have the capacity to borrow more.
American Capital Agency, on the other hand, took advantage of the depressed valuation of mortgage REITs caused by the unpredictable rates and started aggressively buying back its shares and the shares of some of its peers.
During 2013, American Capital Agency bought back about 10% of its own shares, at discounts of up to 25% off book value, which seemed like a better and more instant way to combat rising rates than de-leveraging too much. It also acquired about $400 million worth of rival Hatteras Financial, which was trading at even more attractive discounts for much of the past year.
The Fed is a friend to the mortgage REITs
As long as the Fed projects the inflation rate will remain under 2%, there is little danger of interest rates climbing.
Even though the Fed doesn't want inflation to get too much higher, the number one priority is ensuring the economic recovery continues. The unemployment rate is actually improving better than the Fed had hoped, and in fact the Fed lowered its expectations for the year to 6.0 to 6.1% from 6.1% to 6.3%.
So, even though the latest CPI data actually shows inflation to be a bit beyond the Fed's target at 2.1%, they still project the full-year inflation rate to be between 1.5% and 1.7%. Besides, the Fed's worst fear is raising rates too soon and derailing the recovery. They will need to see evidence that inflation is rising significantly beyond the 2% target before they'll pull the trigger and raise rates.
Judging by their current projections, we should have at least a year before that becomes a real possibility. However, I believe when the rate increases come, they will be smooth and predictable. The reason we saw mortgage rates spike last year was due to the extreme uncertainty surrounding the Fed's taper and its effects. As long as we see rate increases coming, spiking rates shouldn't be too much of a concern.
Smooth sailing for now, but keep an eye out
Rising rates by themselves are not necessarily bad for mREITs, and are an essential part of a healthy economy. It's when rates spike suddenly and rise unpredictably that we run into problems. Hedges become ineffective. Rising rates cause the value of the mortgage-backed securities owned by the REITs to fall, eroding book value and profit margins, but if a steady rise in rates is expected it can be planned for. The spike in rates in mid-2013 was the main reason we saw mREIT share prices drop so much during the latter half of the year.
However, if you note the time period between February and April 2014 on the chart, you'll see both rates and share price move up. The difference is the increase was slow and steady, not a spike.
So, while so far the Fed has been very true to its word and seems set to keep short-term rates very low for the time being, keep an eye out for any unexpected spikes, especially in mortgage rates. However, as long as the Fed keeps rates low (or at least predictable) and home sales remain relatively sluggish, your investments in Annaly and American Capital Agency should be safe.
Matthew Frankel owns shares of Annaly Capital Management. 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.