Mortgage REITs are polarizing figures in the real estate industry and in the investment world. Primarily favored by retail investors due to their potential dividend yields, serious investors often steer clear of mortgage REITs due to their leverage and volatility of earnings.
American Capital Agency Corp (NYSE: AGNC) is a representative of all that works and does not work for mortgage REITs. With an indicated dividend yield of 21.26%, AGNC has the highest yield even among its peer group (that have an average of 13.19%) and is significantly higher than the S&P 500 dividend yield of 2.09%. However, investors looking for dividend returns may be concerned to find that the stock is down 37%, which, simply put, means that despite the dividend yields, an investor would lose money on the stock in the past 12 months. A similar pattern can be seen amongst AGNC’s peers like Annaly (NYSE: NLY) or Chimera (NYSE: CHM).
Mortgage REITS have a straightforward business model is simple and thus, seem to provide low risk arbitrage-type returns, similar to commercial banks The firms borrow at low costs and lever up their balance sheets as much as the current credit environment permits. They then invest in low-risk mortgages and mortgage backed securities, which provide a much higher yield. Nevertheless, these low margin, high leverage bets can only perform well in low rate and easy money environments when charge offs and delinquencies are low. However, adverse movements in long rates leading to bond price rationalization will lead to an immediate slump in the value of their holdings and thus, negatively affect their equity prices.
The other interesting aspect about mortgage REITs is their Betas. For example, AGNC trades at a 0.18 beta and NLY trades at a 0.19 beta. From these numbers it is obvious that these REITs are suitable investments for diversifying a portfolio.
In the current volatile interest rate and mortgage rate scenario, where every move in these rates swings according to the market’s reaction to the Fed, we ask investors to avoid investing in mortgage REITs. With the rise in mortgage rates in the past few months and continuing uncertainty in the market, we think that AGNC’s earnings will negatively surprise the markets. Our forecast is that AGNC may take a large hit on its tradable securities portfolio in the next six months.