Mortgage REITs are all about the yield curve. They borrow on the low end (30- to 60-day LIBOR) to buy mortgages that pay interest on the high end (30-year rates) and then distribute the difference to shareholders as dividends, explains Todd Shaver; here, the editor of Bull Market Report — and a contributor to MoneyShow.com — reviews a trio of mortgage REITs for income-oriented investors.
Under normal circ*mstances, that's a perpetual motion cash machine. And even now, when the spread between short-term borrowing and long-term lending rates has gotten uncomfortably narrow, the people who run these portfolios still find ways to squeeze a half percentage point or two.
In 2019, when the curve fully inverted, that spread got all the way down to 0.55% . . . still positive and still enough to keep cash flowing. That's all it takes to get through the bad times. And then, once the spreads start widening again, distributions rebound fast. The time to lock in a yield is when the curve inverts. If history is any guide, your income might take a hit for a quarter or two, but before you know it, you'll be earning 8-10% a year again.
Leading mortgage real estate investment trust AGNC Investment (AGNC) released its second quarter results a week ago, reporting $315 million in revenues, up 36% YoY, compared to $232 million a year ago. The company posted a profit, or funds from operations (FFOs) of $435 million, or $0.83 per share, as against $400 million, or $0.76.
The mortgage REIT’s book value declined during the quarter to $11.43 per share, compared to $13.12 at the end of the previous quarter. This was owing to the weakness in the agency mortgage-backed securities market, and the anticipation of higher short-term rates driven by fears of a recession, all resulting in substantially high interest rate volatilities during the quarter.
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The firm ended the quarter with a portfolio of $61 billion, with $44 billion in agency mortgage-backed securities, $16 billion in to-be-announced mortgage positions, which are essentially forward trades for mortgage settlements, and $2 billion worth of credit risk transfer and non-Agency securities.
Yield differentials between the 30-year current coupon MBS, and the 10-year treasury note have widened by over 100 basis points over the year, and ended the quarter at a spread of 140 basis points. The only other time when such spreads existed for extended periods was during the Great Recession in 2008, and for mortgage REITs like AGNC, wider spreads result in enhanced earnings in the long run.
Historically such situations have proven to be stellar buy-in opportunities, and with the Federal Reserve making it clear that the preferred monetary policy tool is adjusting federal funds rates, and not balance sheet reduction. With this, the net supply of Agency MBS will stay within the $700 billion range, making it quite attractive for firms such as AGNC.
AGNC is down by over 18% YTD, and 25% from its peak in October with the interest rate hikes eating into its book value. This has pushed the current yield to 11.4%, and the stock trades at just a 10% premium to book value, making it a great opportunity to get in. With robust liquidity, consisting of $10 billion in cash, and $44 billion in debt, it remains well positioned to make the most of these opportunities.
One of the largest mortgage real estate investment trusts, Annaly Capital Management
Like most mREITs, Annaly saw its book value drop 13% during the quarter, resulting in a negative economic return of 9.6% as spreads widened, and interest rate volatility continued to roil operations. The company, however, posted a stellar beat on top and bottom lines, and generated earnings that exceeded dividends by 135%.
Annaly ended the quarter with a portfolio of $82 billion, with $75 billion in highly-liquid agency portfolio. The residential portfolio stood at $4.8 billion, an increase of 10%, followed by the Mortgage Servicing Rights portfolio at $1.7 billion, up 41% YoY, making it the fourth largest purchaser of MSRs YTD, which as we’ve discussed earlier, is a significant hedge against rising interest rates.
This was an eventful quarter for the company, closing five whole loan securitizations worth $2 billion, making it the largest non-bank issuer of Prime Jumbo and Expanded Credit MBS. The residential credit group added a $500 million credit facility, and the MSR platform closed another $500 million, followed by a secondary offering of common stock worth $740 million in May, creating plenty of liquidity for the company.
Despite a challenging environment during the quarter, the clarity on the Federal monetary front, along with the historically attractive spreads should yield higher total returns in the future. After a 14% fall YTD, Annaly shares provide a yield of 12.8%, with excellent dividend coverage, all the while trading at a healthy premium to book.
Rithm Capital (RITM), formerly known as New Residential Investment, released its second quarter results, posting $1.3 billion in revenues, up almost triple YoY, compared to $450 million a year ago. Profits during the quarter remained strong at $145 million, or $0.31 per share.
The real estate investment trust unveiled a flurry of changes extending beyond just its name and stock symbol, with the most monumental one being the rescinding of its contract with external manager Fortress Investment Group. Going forward Rithm will be managed internally, and as a result paid $325 million to terminate its agreement with Fortress, a move that will result in annual savings of $60 million.
Beyond this, Rithm has made numerous other strides to save costs and increase efficiency, most notably in its mortgage business where the annual general and administrative expenses are down from $2.2 billion to $1.9 billion. The company has further reduced capital in its origination business from $2 billion to just $650 million, improving the overall return on capital employed for shareholders.
The firm’s approach to rebalancing its portfolio with the perfect mix of originations, MSRs, companies, and assets, has resulted in a decrease in book value of just 2.2% QoQ. This makes Rithm an outlier among leading mREITs, most of which have posted drastic erosion in book values in face of rising interest rates, an inverting of the yield curve, slowing real estate sales, and a looming recession.
Rithm’s mortgage servicing rights (MSR) portfolio stood at $623 billion in unpaid principal balances during the quarter, with a gain of $515 million as result of rising interest rates and treasury yields. The Servicing segment posted a profit of $620 million, and represents a robust hedge against the originations business which is currently in the midst of a slowdown.
The losses in the trust’s origination segment stood at a minor $26 million, flat from last quarter, owing to lower originations at $19 billion, compared to $23 billion a year ago. The segment, however, continues to see steady improvements in sales margins at 1.95%, as against 1.42% a year ago. Again, the company is working diligently on lowering costs.
The stock remains down by over 7% YTD, even after a significant bounce from the low in June. Rithm Capital represents a stellar opportunity for future gains with yields nearing 10%, good coverage on the dividend, substantial value and synergy gains in recent quarters, as its various operating companies come under the purview of internalized management. The future looks bright. We have confidence in Management and are confident that book value of $12.28 will increase into the mid-teens in the next 1-2 years.
