The mortgage REIT sector has taken a beating since the election, as investors worry that four more years of an Obama administration will continue to squeeze the life out of the popular investment vehicles.
For those looking for a reason or two to look on the bright side, search no further than American Capital Agency's (NASDAQ:AGNC) own Gary Kain. The Bank of America Merrill Lynch Banking and Financial Services Conference gave American Capital's CEO the perfect pulpit from which to make his proclamation: Sure, times are tough for mREITs, but there are good reasons not to panic.
Reason No. 1: Portfolios can be arranged to minimize risk
Kain talked first about the biggest bugaboo scaring investors in the mREIT sector – the prepayment risk issue. While admitting that this problem has accelerated because of QE3, he also noted that there are ways to position a mortgage-backed security portfolio to dampen the chances of prepayment.
The secret sauce here is to pick investments featuring low-principal loans, since fees associated with refinancing will seldom be considered a bargain on such a mortgage, offering a sort of built-in insurance policy. Kain also notes that he likes HARP loans, the government-backed refinance program for underwater borrowers. While these loans are written for LTVs that normally would not qualify, this is also a one-shot deal, meaning that these loans will not be refinanced again, obliterating prepayment risk.
Reason No. 2: Tax rate issues won't affect mREITs
Noting that fiscal cliff issues are upsetting investors -- particularly the fact that tax rates on dividend income might ratchet upwards if no action is taken by Congress -- Kain brings up a very salient fact: REIT dividends will experience no major changes, since they have always been treated as regular, not investment, income. No worries on that score, at least, though changes in the overall tax code may affect income tax rates in general.
American Capital's CEO notes that the current economic environment presents challenges but feels that good management techniques will tamp down much of the risk. This in itself should give investors heart, particularly those with interests in well-managed entities like American Capital, Annaly Capital Management (NYSE:NLY) and Armour Residential (NYSE:ARR).
Like American Capital, both Annaly and Armour are also positioning themselves to ride out tough times. Annaly recently made a bid to purchase CreXus Investments (NYSE: CXS) in order to diversify its MBS portfolio, and Armour has bumped up its portfolio percentage of adjustable-rate mortgages to nearly 22%, giving it some hedge against prepayments.
Mortgage REITs are far from out of the woods, but the best of breed have been checking the headwinds, and planning accordingly. Even if dividends suffer in the short term, investors can rest assured that the best-managed companies have nowhere to go but up.