Author: John Gerard Lewis, Gerard Wealth
Covestor model: Stable High Yield
Disclosure: Long AGNC, ANH, CYS, NLY
The comparative metrics of companies within any industry don’t necessarily follow in lockstep with investment returns. But they can certainly explain some things, particularly those metrics that appear a bit arcane.
Take agency mortgage real estate investment trusts, several of which I personally own and which serve as the engine for the Covestor portfolio that I manage. Agency mREITs primarily hold mortgage securities that are backed by the U.S. government or sponsored entities thereof.
Is it mere coincidence that the one-year total return of American Capital Agency Corp. (AGNC), which had an average second-quarter constant prepayment rate (CPR) of 10%, is 38.87%, while the one-year total return of Anworth Mortgage Asset Corp. (ANH), which had a CPR of 24%, is just 6.84%?
In general terms, CPR measures the percentage of mortgages in an mREIT’s portfolio that are being paid-off. Higher-rate mortgages are more likely to be paid off sooner, so that can lower the return, or “spread,” for an mREIT.
Given the relative performance of these and other prominent agency mREITs, the answer to the question above appears to be no — it’s not mere coincidence that AGNC outperformed ANH given the CPR rates of the two.
As with any industry, underlying performance measurements do generally correspond to financial performance and thereby investment returns. But the difference with regard to mREITs is their uniquely high reliance upon dividends, instead of equity appreciation alone.
Mortgage REITs operate in much the same manner as leveraged bond funds, borrowing at lower short-term rates to invest in higher-yielding, longer-term securities. The product of this arbitrage constitutes most of the total return to investors, especially when the yield curve is steep.
But we’ve seen the yield curve grow flatter over the past year, beginning with the Fed’s Operation Twist initiative, commenced in September 2011.
Thus has the particular art endemic to arbitrage been especially apparent, as some mREIT managements have more deftly navigated the flattening curve than others. And that disparate performance can certainly be seen in the underlying metrics.
For example, CYS Investments, Inc. (CYS) has been another top performer, returning 27.42% over the past year, and it’s not difficult to understand why. It increased book value by 2.9%, nearly twice the rate of any other mREIT that I or my firm owns. Higher book value can boost the stock price — the other component of shareholder return.
By contrast, Annaly Capital Management, Inc. (NLY) increased its book value by just 0.3% during the quarter and carried an average CPR of 19%. Its total return over the past year has been just 8.78%, while the S&P 500 index has risen more than twice as much — 18.85%.
Annaly is frequently touted as the bellwether stock in the category, but it appears that this reputation was earned on performance from several years ago. Still, I respected the company’s alleged stature enough that I wrote an apologia for it a while back.
Soon thereafter, I began to become less convinced and in June unloaded most of my personal stake in NLY, although I maintained the position in my Stable High Yield model portfolio. But even there, the odds of at least a partial divestiture are rising.
And that brings us back to the aforementioned ANH, which seems certain for the chopping block soon. Relative to other agency mREITs, which have generally been stellar performers, the poor thing seems hapless — or at least not worth holding any longer.
