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TheStreet Open House

Investing In MREITs In A Time Of Rising Rates

Stocks in this article: AICMOEFCNRZ

By Darren McCammon

The second quarter of 2013 was tumultuous for mortgage real estate investment trust (mREIT) securities. aThe Federal Reserve's surprise decision not to start tapering created a storm which caught most unsuspecting and under-hedged.

The market sold mREITs off as rates rose, and in many cases correctly anticipated significant book value declines. However, a few (Arlington Asset (AI), Ellington Financial (EFC), New Residential Investment (NRZ), and Capstead Mortgage (CMO)) had already battened down their hatches and thus suffered only minor damage.

Others were late to prepare for the danger, but eventually followed suit, reducing their leverage and increased their hedges. The storm was survived and most in the mREIT industry are now more cautious and better prepared to weather future challenges. In contrast, third quarter earnings are likely to show clear sailing for the mREIT's with a favorable wind at their backs.

Q3 has been an interesting quarter for the world, but relatively benign for mREITs. Mortgage Backed Security (MBS) values were stable during the quarter, drifting down slightly in anticipation of a September taper, then back up at the end of the quarter when that taper didn't happen.

While most mREIT's have significantly lowered risk by reducing leverage and increasing hedging, it turns out, at least in Q3, it wasn't needed. Also reinforcing this benign outlook for Q3, EFC and CYS Investments (CYS) have already reported book values which were essentially flat with Q2.

I expect much of the same as the rest of the mREIT's report earnings, as well as flat book values resulting in a gradual calming influence on the sector. This, and the reduced risk profiles, should help to settle fears of continued MBS and book value losses.

We may also see a small and gradual increase in interest rate spreads. mREITs make their money by borrowing at short term repo rates and using those funds to buy MBS paying longer term, predominantely higher, mortgage rates.

This is commonly referred to as the spread. However, increased rates were not immediately apparent in Q2 spreads despite a roughly 1% increase in mortgage rates. What may not have been taken into consideration is the suddenness of the change.

Rates affect book value immediately, but there can be a delay before the portfolio of assets an mREIT holds rolls over into higher spreads. Also many mREITs increased hedging at the end of the second quarter, the cost of which further reduced the spread.

For Q3 earnings announcements, we could see some of these increased spreads start to come through. This should have a further calming influence on mREIT investors and reinforce that higher interest rates, aren't all bad news. Indeed an environment of gradually increasing mortgage rates, largely hedged book values, and continuing low short term repo rates, can be beneficial.

Looking into the future, aJanet Yellen has been nominated as the new Fed chief. aWhile anything can happen, it is widely believed she will be confirmed. Furthermore, Mrs. Yellen is a known dove. Indeed she has been a noted proponent of keeping interest rates low until unemployment improves significantly.

In my opinion, it is unlikely her first act running the Fed would be to raise interest rates, particularly with another possible debt crisis and partial government shutdown looming. aIt is therefore unlikely, I believe, that we will see the beginning of taper until at least March, maybe longer if the economy doesn't keep improving.

I have no way of knowing this for sure, but assuming a slow taper of $10 billion in reduced bond purchases a month starting in March, you are probably looking out until the beginning of 2015 before the Fed is done. That means the Fed continues to add to its bond holdings through all of 2014 and most likely doesn't start actually increasing the Fed funds rate until 2015.

That is a good environment for mREITs, Business Development Companies (BDC) and any other company which benefits from borrowing short and lending long. This is a case where poor economic growth and a dysfunctional government is a good thing for mREITs.

I have no way of knowing for this for sure, but I belive mREITs are likely to be looking at a calming and profitable Q3 with an improving outlook over the next 3-6 months and hedged book values. In this situation investors should gradually realize that existing discounts to those book values are largely unwarranted.

The discounts should shrink over time producing capital gains. aFear has created an opportunity; mREITs represent not only high dividends but their current discounts provide a margin of error. aAs such they should be over-weighted in income focused portfolios.

DISCLAIMER: The investments discussed are held in client accounts as of September 30, 2013. These investments may or may not be currently held in client accounts. REITs may be affected by economic conditions including credit and interest rate risks, as well as risks associated with small- and mid-cap investments. Past performance is no guarantee of future results.

Darren McCammon

Darren McCammon

I am the principal at ProActive Financial LLC in Reno, NV, a financial planning firm. I have worked to provide

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