It's been about six months since I last addressed mortgage real estate investment trusts (REITs). Given that treasury yields and mortgage rates have moved in the opposite direction of what the consensus was when I wrote that last column, this is a good time to revisit the issue.
When I wrote about REITs last September the prevailing market expectation for bond yields and mortgage rates was that they were both set to rise. It was believed that the increase would drive down the market value of the mortgage holdings of the REIT's and be reflected in declining market prices for them.
Since then, however, long-end treasury yields and mortgage rates have declined dramatically. Instead of rising in price, the REIT's have all declined, too.
The reason for the decline is that rising rates push down the value of existing mortgage holdings . But falling rates increase the potential for an acceleration of prepayments by way of an increase in the rate of mortgage refinancing. That causes the premium value of the higher -yielding mortgages to disappear when a mortgage is paid off sooner than expected.
The price performance of the REITs I've been tracking in this column series since last September 17, has been:
Annaly Capital Management, Inc. (NLY) , minus 8.5%,; PennyMac Mortgage Investment Trust (PMT), minus 1%,; Chimera Investment Corporation (CIM), minus 2%; American Capital Agency Corp. (AGNC), minus 5%; CYS Investments, Inc. (CYS), minus 5%; and Capstead Mortgage Corp. (CMO), minus 9%.
The majority of this negative move has occurred over the past few months as treasury yields and mortgage rates have plunged and expectations for an acceleration of prepayments of existing mortgages have increased.
Headlines such as this one from Reuters in January, U.S. mortgage applications surge; 30-year rate below 4 percent: MBA, has helped to spook REIT investors out of their holdings.
The logical sequence is that falling mortgage rates will cause prepayments to increase and force REIT's to reinvest the proceeds back into lower yielding mortgages. That will lead to a reduction in the dividend stream provided by the REIT to investors.
The expected reduction in the income stream provided by the REIT then mandates that, relative to what the REIT was priced at before rates declined, it must now be worth less. Although this logic is rational anecdotally, it does not align with the real potential for prepayments, which are much lower than the headlines on refinance activity would seem to imply.
As I discussed last week in the column, Wells Fargo Is Headed for Trouble, although mortgage rates have declined to their lowest level since May of 2013, they are still well above the lows put in then.
Although mortgage rates have declined precipitously over the past few months, this does not address a wide field. The majority of those eligible to refinance and for which the rate reduction available for doing so warrants absorbing the fees associated with the action. Those people are those who purchased a home between roughly September of 2013 and September of 2014.
That's a very shallow group of potential refinancers with the majority of them already being reflected in the surge of refinance activity that's occurred over the past few months.
Unless mortgage rates fall below the lows of the first quarter of 2013, which means to or below the 3% par level for a 30 year conventional conforming mortgage fixed rate, there will be a precipitous decline in refinance activity in the immediate future.
The vast majority of those eligible to refinance up to the early 2013 lows in rates have already done so. There may be some that procrastinated then that do so now, but they are probably already counted in the recent surge of refinance activity as well.
In order for mortgage rates to get to the lows necessary for prepayments to represent a legitimate reduction in income produced by the REIT's for investors, the 10-year treasury yield will have to decline to and sustain record lows of below 1.5%.
The probability of that happening in the immediate future are low. The recent spike down in treasury yields that dragged the 10-year treasury yield to 1.65% a few days ago was primarily driven by expectations that the Fed would increase the Fed Funds rate in June.
In just the last few days, however, that belief has reversed course, as I discussed Wednesday, and this has helped to propel the 10-year yield back up to the current level of 1.81%.
If the Fed does not soon signal that they will not raise rates in June, and instead continues to signal that they will raise rates in June, the 10-year yield could indeed crash to record low yields.
If that were to happen I would advise selling the REITs. For now, I think that is a low probability.
