As expected, the Fed’s twisting and easing acrobatics over the past year and a half ultimately took its toll on agency mortgage real estate investment trusts (mREITs). It took awhile for this deliberate suppression of long-term rates to finally hit their stock prices, but mREITs finally got clobbered in the fourth quarter of 2012.
The Fed-manipulated decline in long-term interest rates reduced the spread that mREITs arbitrage to squeeze out their high yields. There was only minimal effect on the prices of agency mREITs (those that buy mostly government guaranteed securities) over the first 12 months following the initiation of Operation Twist in September of 2011. Some mREITs had already begun to cut their dividends, but several nonetheless managed to climb to all-time high prices in September 2012.
But then the roof fell in. By the middle of November, most agency mREITs were down more than 20% from those highs, around three times the decline of the Standard & Poor’s 500 during that period. Ben Bernanke was killing the mREITs, as I see it.
All of this also had the expected negative effect on the Covestor Stable High Yield portfolio that I manage. High-yielding mREITs can comprise up to half of the portfolio, with the other end of the “barbell” consisting of short-term bonds and near-cash securities. This counterweight component mitigated the damage, in my opinion, but by the middle of November the return since inception had fallen from a September peak of 18% to 8% (net of fees).
Now, the design of the Stable High Yield model does take into account such risks. The model relies on the prospect that, over the long term, mREIT prices and dividends will provide what I consider to be acceptable total returns. Intervening periods of declines are anticipated – and tolerated – with my estimation is that these securities will perform well over time. The objective of the model is to tolerate potential periods of decline, and my expectation is that these securities will perform well over time.
And so today we find ourselves asking: Is the recent dramatic decline of agency mREITs over? I believe that it is.
Among the agency mREITs held in Stable High Yield, American Capital Agency Corp. (AGNC) has recovered approximately 34% of its September to November decline (as of the Jan. 18 closing). CYS Investments (CYS) has recovered around 36%. Capstead Mortgage (CMO) has recovered about 33%. And Hatteras Capital (HTS) has recovered approximately 49%.
The reason for this positive retracement is most likely the swirl of recent pronouncements from and commentary about the Fed. Mr. Bernanke has steadfastly denied that the end of the low-rate policy is in sight, though it seems contrary rumblings from internal dissidents and external groupies have been enough to hearten mREIT investors.
But mREITs have benefited from more than mere whispering and jawboning, as I see it. It has not escaped investors that interest rate spreads have reversed course and widened recently, giving mREIT managers a bigger field on which to play.
The steady decline of long-term rates vis-à-vis short-term rates reached its narrowest spread early last summer. The 20-year Treasury bond was 87 basis points lower on June 4, 2012 than it was at the beginning of Operation Twist on September 21, 2011.
But by Jan. 18, 2013, the decline was only 47 basis points, evidence that the spread between short- and long-term rates has been widening (short-term rates remained at near rock bottom yield throughout this period).
If indeed the arbitrage prospects for mREIT have stabilized, as I think they have, then I believe this investment sector has become appealing once again. The four agency mREITs in my model enjoy an average yield of nearly 14% (as of 1/23), certainly an attractive return, in my opinion, and especially so if prices have bottomed out.
Disclosure: The author is long AGNC, CYS, CMO, HTS personally, as well as in the holdings in the Stable High Yield model that he manages at Covestor.
The investments discussed are held in client accounts as of January 23. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.
