President of Investment Research Brian Nelson talks mortgage REITs and the concept of spread risk that may lead to steep book value declines and weakened dividend health across the industry. ~5 mins.
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Kris Rosemann:
Hi, I am Kris Rosemann for Valuentum Securities. Today on our podcast President of Investment Research Brian Nelson is going walk us through some of our thoughts on mortgage REITs (REM). Brian could you explain to us why we at Valuentum don’t like mortgage REITs and maybe go through some of the risks individual investors should be concerned with that are not as prevalent as a normal operating company?
Brian Nelson, CFA
That is a great intro. Thank you very much for having me Mr. Rosemann.
The mortgage REIT industry is a sub-segment of the broader real estate investment trust sector (VNQ), and the reason why this particular subset of REITs gets a lot of attention is because their dividend yields are so high, oftentimes 10%, double-digit yields — that itself is a red flag.
But the mortgage REITs in particular have a business model at face value may not seem so risky. After all, companies like AGNC Investment Corp (AGNC), which previously was American Capital Agency. They’re a REIT that invests in agency securities that has principal and interest payments guaranteed by a US-government sponsored entity like Fannie (FNMA) or Freddie (FMCC). It sounds like these particular entities have the backing of a very strong credit and that is true.
However, these particular entities employ strategies that don’t hedge against all particular risks. So, for example, they may hedge against interest-rate risk, hedge against prepayment risk and extension risk, to a degree, but they don’t hedge against spread risk — and that was an area that we identified in 2012 and 2013 that allowed us to highlight to our members the significant risks of these businesses models in advance (of the decline).
Most mortgage REITs generate net interest income off of their portfolio, and they apply leverage to that to gross it up to a solid return on equity. What types of leverage are we talking about? Leverage of 7-8 times. AGNC Investment Corp, for example, had a tangible net book value at-risk leverage of 7.7 times in its last quarter — that is an extreme amount of leverage. I think most investors look at the net interest income of the company as a way to feel comfortable about that investment.
However, that is only one aspect of their (mortgage REIT) business. The other aspect of their business is exposed to what we call the spread risk. When the spread between the yield on a mortgage REIT’s investments and benchmark interest rates such as the US Treasury widens, for example, the value of their existing portfolio declines, and what you have is a (negative) loss in what’s called “Other Comprehensives Losses.” What we saw in 2012 and 2013 was that the net interest income, the spread income that the REIT was generating was strong, but the value of their existing portfolio was falling as the spread risk was overwhelming their net interest income.
So we identified that risk as a core part of a mortgage REIT’s business model and what we’ve seen over the past several years was really a decline in the equity prices of mortgage REITs. This particular dynamic, this spread risk, which a lot of the mortgage REITs do not hedge completely for, is a reason why their stock prices continue to trade below their tangible book values (in our opinion). [The other reason is expectations for economic-value destruction in future periods.]
While these mortgage REITs claim to have a strong backing of credit, the very idea that they are having to leverage so much, 7-8 times, and the fact that they are still exposed to declines in the value of the instruments they hold on their books, these particular dividend paying equities are much more risky then what meets the eye. So we tend to be very cautious on mortgage REITs, and we think this “Other Comprehensive Loss” dynamic, the spread risk dynamic, isn’t well understood within the investment community.
Kris:
Wow, that is some great insights Brian. Thank you for your time — sounds like there are plenty of reasons for pause for investors considering mortgage REITs.
Brian:
Thanks for having me Kris.
Kris:
Thank you.
Tickerized for holdings in the REM and for various other ETFs.