If Annaly Capital Management (NYSE:NLY), ARMOUR Residential REIT (NYSE:ARR), and American Capital Agency's (NASDAQ:AGNC) double-digit dividend yields weren't exciting enough, as asset-based businesses, mortgage REITs trade based on their price-to-book value, and all three stocks are currently trading at a significant discount to their historic book values.
However, because some stocks are cheap for good reason, today I'll dig into why these companies are trading at such discounts, identify the upside, and determine which high-yielding option is the best buy today.
Why are they so cheap?
As "agency" mortgage REITs, Annaly, American Capital Agency, and ARMOUR make short-term borrowings to invest in longer-term residential mortgage-backed securities -- pools of housing debt -- packaged by Fannie Mae, Freddie Mac, or Ginnie Mae.
While these securities are guaranteed against defaults, they are extremely vulnerable to rising interest rates that lower the market value of currently held securities. Moreover, because they borrow based on short-term rates, an increase in borrowing costs will cut into profitability.
To put it plainly, the threat of rising interest rates is like a punch in the face. If you see it coming and do nothing, it is going to hurt a lot. Cover your face, however, and you can limit some of the damage. And that's really what we've seen from these companies over the past year -- an attempt to cover their faces.
This has involved lowering leverage -- borrowing less compared to equity -- buying shorter duration assets, and using derivatives to exchange their floating interest rate payments for fixed-rates. The downside to these defensive moves, however, has been limited profitability and dividend cuts -- ultimately, leading to a cheaper valuation.
What's the upside?
ARMOUR Residential REIT: ARMOUR's extremely low valuation is, in my opinion, it's most interesting quality. I have gone into more depth on ARMOUR recently, but the abridged version is that nothing about the company's past performance, assets, or investment approach, excites me.
Annaly Capital Management: Unlike ARMOUR and American Capital Agency -- who went public following the financial crisis -- Annaly has been around since 1997, and is one of the few mortgage REITs that can boast surviving more than one market cycle. In fact, Annaly's stock has historically performed best immediately following a recession -- a time when most companies are still scrambling to put the pieces back together.
Also, with the acquisition of CreXus in January 2013, Annaly has diversified into owning commercial real estate. Although the $1.6 billion in commercial assets only accounts for 12% of the company's equity, the high-yielding investments are an intriguing part of their business and will be something to watch.
American Capital Agency: Lead by President and CIO Gary Kain, American Capital Agency has what I believe is one of the best management teams in the sector. Whether it's investing in competing mREITs stock, switching between 15-year and 30-year mortgages when opportunity presents, or operating with a larger duration gap -- difference between length of assets and liabilities -- to benefit from falling interest rates, American Capital Agency always seems to stay one step ahead, and it's the reason they have been one of the top performing agency mortgage REITs over the last five years.
The best cheap mortgage REIT
With reduced books values, smaller dividends, and uncertainty surrounding rising interest rates, none of the stocks mentioned today have been unfairly beaten down. With that said, buying into uncertainty tends to go with the territory when you're looking at cheap stocks.
So, while I do believe the road ahead will be difficult, I'm betting on American Capital Agency's management to best navigate the storm. I think Annaly's track record earns it second best, and -- despite their incising valuation -- I see ARMOUR as a fairly distant third.
Dave Koppenheffer 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.