Calculating the Spread and the Fed

 | May 20, 2013 | 11:00 AM EDT  | Comments
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The agency mREIT sector's malaise has hit shares of said "Portfolio Guru, LLC shareholding Armour Residential REIT (ARR), whose shares have fallen 7.0% in 2013 vs. the S&P 500's 16.9% gain.

Agency mREITs borrow money to buy mortgage-backed securities guaranteed by FNMA, GNMA, or FHLMC. The difference between their borrowing cost (in the repo market) and the interest rate earned on MBS holdings is their "spread." That spread multiplied by the leverage ratio is their profit margin. mREITs are leveraged bond funds dressed up as common stocks, and have to pay out 90% of what they earn to maintain REIT status (and pay no corporate taxes.)

Why are mREITs so out of favor? Two reasons: one fundamental, and one psychological.

Spreads have narrowed -- If we look at a 3-month treasury vs. 30-year fixed mortgage rate, we see why the market has gone from "Buy" to "Hate" on mREITs (see Chart.) That spread -- currently at 3.38% -- is at post-Crisis lows, and thus the squeeze on mREIT profit margins and the stocks.

But it's the second derivative that matters, and as the second chart shows, this spread has actually widened since the announcement of QE4 on December 12. So, the reality of QE4 isn't as bad as the mortgage-bond market expected in November.

 

Fear of the Fed -- As the Fed has spurred a rally in the overall market, fear that the Fed will extract profitability from the MBS market (Chart 2 shows this hasn't happened) has torpedoed mREIT stocks. To buy them now, you have to fight both the "tape" and the Fed. Too risky?

 

Yes, mREITs are risky, but the Fed's presence in that market is not new. The Fed bought $1.25 trillion of agency MBS from 12/08 to 3/10 and since September 2011 has been reinvesting proceeds into more MBS. The announcement of $40 billion/month in additional purchases (QE3) drew all the headlines last fall, but, as of year-end 2012, the Fed held $941 billion in MBS. mREITs navigated the Fed-affected MBS waters for four years, so it's hard to see why QE3 -- which began in January -- is "the killer."

The two factors above obscure the biggest risk to mREIT profits -- not wild interest rate swings (mREIT hedges perform best in dire conditions,) but prepayments. Prepayments occur when a mortgage in the pool either goes into default or the homeowner chooses to repay early. The latter is now more common than the former, but for the mREIT it doesn't matter. They are paid face value by Fannie, Freddie or Ginnie. That's the beauty of the guarantee, but it's also a profit drag because MBS are trading at premium. So to get paid back at par generates a capital loss.

Prepayment rates rose in 2012 due to historically-low mortgage rates and mortgage-assistance programs, notably HARP. Again, it's the second derivative, and after a jump in the fourth quarter of 2012, prepayment rates in ARR's portfolio have returned to historical norms (Chart 3.)  mREITs have been Fed-proofing their portfolios, and ARR's prepayment decline shows their "long-end of the curve" strategy is bearing fruit.

So, we are searching for a bottom on ARR's dividend rate. ARR pays monthly, but sets the rate quarterly based on management's profit expectations. ARR's dividend payment has declined from $0.12/month in the third quarter of 2011 to $0.07/month for the second quarter of 2013. While ARR still sports a 14% current yield, the idea that ARR's dividend will decline further is a prevalent one in the markets.

I believe there is a bottoming here, and while the dividend may fall by a penny in coming quarters due to vagaries in MBS pricing/spreads, we really have seen "as bad as it gets" for the mREITs. ARR offers an extremely high yield, and for income without agita, Armour's preferreds (ARR.A) (ARR.B) offer fixed monthly payments.

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