In this day and age of almost nonexistent interest rates, one sector that has done quite well by investors is mortgage REITs. These companies have actually reaped benefits from the low-short-term-rate environment, and their yields and dividends have been an oasis for parched investors seeking relief from low returns.
Lately, though, there have been some rumblings regarding the performance of these companies, whisperings that maybe the heyday of mREITs is over. Is it time to panic? Let's take a look at some of the issues that may disrupt the smooth sailing that these companies have enjoyed so far.
1. Interest rate spreads are getting narrower.
Mortgage REITs make much of their money by borrowing at low short-term rates, then buying assets with higher long-term rates. This has worked very well for these entities since the recession took hold, but the yield curve is slowly flattening, which cuts into profits. While short-term rates remain low, Federal Reserve actions to help float all boats have depressed long-term rates, such as those for mortgages.
Invesco Mortgage Capital
2. Accelerated prepayments could soon be a real problem.
The refinance boom is a godsend for borrowers, who can save a little money each month by taking advantage of lower mortgage rates. It is an even bigger boon for banks, which can make oodles of money helping homeowners save a little. Unfortunately, it is a bad omen for mREITs.
Just as Invesco noted the issue with ARM resets these days, refinancing presents a similar problem when higher-rate mortgages are paid off as the borrower takes out a new loan at a lower rate. Recently, FBR Capital Markets downgraded top-drawer REIT Annaly Capital Management
Of course, just one analyst's opinion does not a trend make, but FBR also argues that a dividend cut may also be in Annaly's future. The REIT has decreased its dividend payments over the past year, though the most recent stayed stable. Unfortunately, this was possible because Annaly sold some of its assets -- which is normal for mortgage REITs but less sustainable than collecting interest. Replacing those assets with current mortgage-based securities may crimp margins even more.
Other mREITs are taking notice of this phenomenon, too. American Capital Agency
3. Fierce competition for MBS vehicles is driving prices higher.
Mortgage REIT managers seem the most concerned with the current market for MBS's, which is much more crowded these days. Investors want vehicles that pay, and interest in these securities is high -- which results in higher prices. Cypress Sharpridge Investments'
It's a valid concern. Investors are falling over one another to pay premium prices for MBS's that sport the type of mortgages that are the least apt to be paid early -- namely, those written for amounts under $85,000. With overall MBS prices so high, investors consider it a bargain to pay a little more than face value for those with some degree of insurance against prepayment. Still, if refinance levels ratchet up appreciably, these investors may find themselves on the losing end of the gamble.
Some bright spots on the horizon
All of these headwinds facing mREITs are worth consideration, but certainly don't mean that these companies are in a downward spiral. For mREITs that invest in non-agency MBS's, things are looking up. Analysts note that revised capital rules for banks mean that senior nonagency MBSs will be treated differently, with more emphasis on underlying performance rather than credit ratings. The uptick in prices can be a plus, too, as noted by MFA Financial
For Annaly, management is aware of the prepayment risk, noting that it is nowhere near the levels of 2003, a rough patch that the company managed to work through. It is possible, too, that Annaly has been selling those MBS's that have a higher prepayment risk to backfill its dividend, and replacing them with low-prepayment-risk securities, as Cypress has done. In that case, the effects of that type of program should be evident in later quarters.
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Fool contributor Amanda Alix owns no shares in the companies mentioned above. The Motley Fool owns shares of Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.