The COVID-19 pandemic has been downright terrible for the mortgage actual property funding belief (mREIT) sector. Within the early days of the pandemic, liquidity within the mortgage market dried up and the businesses had been beset with margin calls. This pressured them to shrink their portfolios and minimize their dividends. As soon as rates of interest had been minimize to zero, a refinancing wave induced their portfolios to repay early, costing them years of anticipated earnings. Lastly, the rise in charges for the reason that starting of the yr has pushed guide values decrease.
In the end, the sector is likely to be getting a extra favorable surroundings. Fascinated by double-digit dividend yields? Then take note of the mortgage REIT sector.Â
Picture supply: Getty Pictures.
Mortgage REITs have a special enterprise mannequin
Mortgage REITs like AGNC Funding (AGNC -3.25%) have a special enterprise mannequin from most REITs. Most REITs spend money on properties and observe a landlord/tenant mannequin. They develop properties and finance them with long-term debt. They then lease out the properties and earn a selection between their lease and their curiosity value. It’s a comparatively easy-to-understand strategy.Â
Mortgage REITs do not spend money on properties, nevertheless — they spend money on actual property debt, i.e., mortgages. AGNC focuses on mortgages which are assured by the U.S. authorities. In the event you lately purchased a home and took out a mortgage, chances are high it was assured by Fannie Mae or Freddie Mac after which securitized right into a mortgage-backed safety. AGNC focuses on these securities.Â
The Fed has been a headwind, however shall be much less of a problem going ahead
The mortgage REIT market has taken a beating as rates of interest have risen amid fears that the Federal Reserve will start to unload its holdings of mortgage-backed securities that it has purchased since quantitative easing started in 2008 or so. It at present holds about $2.7 trillion price of mortgages, or over 100% of 2022’s anticipated mortgage manufacturing. This anticipated provide has weighed on the sector.Â
Mortgage-backed securities are extremely delicate to rate of interest volatility. In different phrases, when charges are all over, mortgage-backed securities are typically unattractive relative to Treasuries. Mortgage-backed securities comprise the identical quantity of credit score threat as Treasuries (i.e., no credit score threat), however they pay greater returns. This additional return is not “free” — it represents the extra sensitivity to rates of interest. When charges rise, mortgage-backed securities fall sooner than Treasuries. When charges fall, they underperform Treasuries. It is because debtors can all the time repay their mortgage early. To compensate for that threat, mortgage-backed securities pay greater yields. Mortgage REITs like AGNC Funding are specialists in managing that threat (referred to as convexity threat).Â
Mortgage-backed securities are probably the most engaging they’ve been in years
Because the Fed has hiked the federal funds charge, the yield curve (the distinction between long-term and short-term rates of interest) has inverted. This implies short-term rates of interest are greater than long-term charges. Whereas inversion typically is a recessionary sign, and it additionally appears to point that longer-term rates of interest have stabilized. That is excellent news for mortgage-backed securities traders like AGNC Funding. Â
For AGNC, the potential returns on its portfolio are fairly engaging. The yields that mortgage-backed securities earn versus Treasuries, or the unfold, are probably the most engaging they’ve been in years. Because of this earnings ought to be rising, all issues being equal. Because the Federal Reserve winds up its charge hikes by the tip of the yr, a giant cloud over AGNC’s head ought to go away. The tip of the climbing cycle ought to damp rate of interest volatility generally, which implies mortgage-backed securities ought to outperform Treasuries.Â
Mortgage REITs aren’t a purchase but, however they need to be checked out in late 2022 or early 2023
Mortgage REITs pay unusually giant dividend yields. At present ranges, AGNC’s inventory yields 13.1%. Mortgage REITs aren’t for the faint of coronary heart, as they’re extremely vulnerable to monetary upheaval. That mentioned, the market surroundings for the sector has been horrible for the reason that pandemic started. The outlook is starting to brighten. Buyers ought to begin wanting on the sector now, with a watch towards shopping for late within the yr because the Fed wraps up its tightening cycle. Mortgage REITs aren’t a purchase but (undoubtedly anticipate Q3 earnings), however they need to be on an earnings investor’s radar display screen.
