While investors ideally like to find companies that are attractive long-term investments that can be held for many years, some types of stocks are good investments only during certain cycles. One investment class that fits this category is agency mortgage REITs (real estate investment trusts).
These firms invest in mortgage-backed securities (“MBS”) that are backed by the government or government-sponsored agencies such as Ginnie Mae, Fannie Mae, and Freddie Mac. Two companies that use this strategy are AGNC Investment (NASDAQ: AGNC) and Annaly Capital Management (NYSE: NLY). Both have attractive yields of over 13% and are leaders in the space.
So, is now the right time to buy these high-yielding stocks? Let’s find out why the answer might be yes.
What the heck is a mortgage REIT?
Mortgage REITs are essentially investment intermediaries that own portfolios of mortgages. Companies generate returns by earning a spread between their cost of financing (short-term debt used to purchase MBS) and the yield on the mortgages in their portfolios. For example, if a firm buys a mortgage with a yield of 6% and the cost of financing is 3%, this will generate a spread of 3%. These firms then use leverage to increase their returns.
Firms typically use hedging to lock in these short-term interest rates for the same period that matches the duration of their portfolios. This helps eliminate the risk of funding costs rising, spreads narrowing, or short-term rates becoming higher than long-term rates.
Given that agency-backed mortgage-backed securities are backed by government agencies, investments in agency MBS carry limited credit risk because these investments are backed by the government. Over 88% of Annaly’s portfolio and 97% of AGNC’s portfolio are in agency-backed MBS, so Annaly carries slightly more credit risk.
However, limited credit risk does not mean that investing in agency MBS is risk-free.
Hard period
While agency mortgage REITs face minimal credit risk and lock in their financing costs by hedging, mortgage REITs face other risks. Because mortgages are fixed-income investments, they carry interest rate risk. As with any type of bond, when interest rates go up, the price of the bond, or in this case MBS, goes down. Why? Because if the newly issued MBS yields a higher rate, the value of the older MBS must decrease to match the current rate.
In March 2022, the Federal Reserve began aggressively raising interest rates from a range of 0.25-0.50% to 5.25-5.50% by the summer of 2023. Not surprisingly, mortgage rates also rose.
Mortgage REITs, meanwhile, saw the value of their portfolios, as reflected in their book value, collapse during that period. For example, AGNC saw its book value decline by nearly -50% from the beginning of 2022 to the end of 2023, while others saw similar declines. Given that book value is essentially the value of the mortgage REIT’s portfolio, these stocks are typically valued at a slight premium or discount to their book value. Both Annaly and AGNC are currently trading slightly above their book values.
AGNC book value (per share) data from YCharts
During this same period, mortgage REITs were also affected by the widening of the spread between agency MBS and 10-year Treasury yields. Bond yields, including agency MBS, typically trade at a premium to Treasury yields. The spread between yields on government bonds and other bonds can narrow and widen depending on the environment.
Better times are ahead
Not surprisingly, 2022 and 2023 were bad years for owning mortgage REITs, as higher interest rates combined with spreads moving from historically low levels to historically high levels hurt stocks.
However, there are several reasons why 2024 could be the perfect time to own stocks like Annaly and AGNC over the next few years. First, the Federal Reserve has signaled that it plans to cut interest rates this year, while Fed officials generally expect the Fed funds rate to return to 2.5% by 2026. This is important because while increased interest rates reduce the mortgage REIT’s book, value, lower rates increase book value.
Meanwhile, spreads remain at historically high levels. This does two things. First, it makes current investments attractive as REITs can get higher yields and spreads. Second, if spreads narrow, it will help book value.
Annaly and AGNC also have less leverage than they used to in the past before the pandemic. For example, Annaly had economic leverage, which accounts for asset volatility, of 5.7x at the end of 2023 versus 7.0x at the end of 2018, while AGNC had leverage of 7.0x compared to 9.0x at the end of 2018 2018
Why is this important? Because firms have the ability to add leverage and increase MBS purchases to generate more net investment income. The net investment income comes from the distributed income it makes and helps keep their dividends stable.
Once these catalysts unfold over the next few years, mortgage REITs should simply enjoy a more normal interest rate environment thereafter. And investors can enjoy collecting the steady dividends they pay. The biggest risk for investors would be if mortgage rates rise to higher levels from now on.
It’s time to buy
The market is currently set to move from a very difficult environment for mortgage REITs to a potentially great period for the sector. If the Fed begins the rate-cutting cycle it has signaled, these could be great investments over the next few years.
While the entire sector should benefit, Annaly and AGNC are two top stocks to look at given their long track records in the space.
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Jeffrey Saylor holds positions in Annaly Capital Management. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
Is now the time to invest in Annaly and AGNC? What you need to know about mortgage REITs was originally published by The Motley Fool
