The Federal Reserve this week is expected to approve the first of what will likely be several prime lending rate cuts over the next couple of years in its efforts to keep the U.S. economy on an even keel moving forward. Perhaps no sector of that economy is set to benefit as much as the housing sector, and more specifically mortgage REITs (real estate investment trusts).
In simple terms, mortgage REITs are specialized companies that invest in mortgage-backed securities , or MBS. Taking the explanation to another level, these REITs fund these MBS investments using short-term financing vehicles, such as repurchase agreements (repos), that they then hedge out to more closely match the duration of the MBS they own. They ultimately make money through the spread in interest rates between their funding costs and the coupons of their MBS investments, which they further boost through leverage.
The investment income mortgage REITs generate is then largely paid out to investors in the form of dividends (as required by the tax structure these REITs operate under).
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Falling interest rates greatly benefit mortgage REITs
Mortgage REITs are typically valued based on the value of their MBS portfolios, which is reflected in their book value per share. The companies in this sector went through a few tough years when the Fed aggressively raised rates. MBS are fixed-income securities, all of which are exposed to what is known as interest-rate risk .
This is simply the loss in market value a fixed-rate security, such as a bond, experiences when investors can get a higher coupon in a similar fixed-rate security. For example, if an investor owned a Treasury bond with a 4% coupon, they could not sell that bond at par value and buy a new bond with a 6% coupon. Instead, if they wanted to sell that bond before maturity, they would have to sell it at a discount based on similar bond yields.
Thus, when the Fed aggressively embarked on a rate hiking campaign, the market value of the MBS that mortgage REITs held lost value. Now with the Fed cutting rates, these companies should now start to see their book values improve.
Notably, mortgage REITs hedge their interest rate risk to an extent, so it isn't actually the biggest driver in moving the value of their portfolios. While the companies were hurt by higher interest rates, it was the yield spreads between government agency-backed MBS and Treasuries widening that had the biggest impact on the values of their portfolios.
Moving forward, the spreads between government agency-backed MBS and Treasuries narrowing will have the biggest positive impact on the value of agency mortgage REITs' MBS portfolios and their stocks. And there is good reason to believe that the spreads will begin to narrow as the Fed cuts rates.
Over the past few years, the mortgage carry trade has generally been unattractive to banks and other institutions. There was no need for banks to step into MBS when mortgage rates were rising. Even after they stopped rising, the spread between short-term rates and MBS wasn't that attractive. At the same time, some regional banks, such as SVB Financial 's Silicon Valley Bank, got into significant financial difficulties due to their unbalanced MBS portfolios.
With many banks and other buyers avoiding the MBS market, there was more MBS supply, which in turn led to the widening of MBS-to-Treasury spreads. Now, as the Fed cuts rates, the yield curve (the difference between short-term and long-term rates) should begin to steepen, drawing in more banks and other institutions to the MBS market. This, in turn, should narrow what have been historically wide spreads over the past few years.
Two stocks set to benefit
Two of the stocks most set to benefit from this Fed-cutting environment over the next few years are AGNC Investment (NASDAQ: AGNC) and Annaly Capital Management (NYSE: NLY) . Both companies primarily invest in agency MBS, which carries virtually no credit risk because the mortgages are federally insured.
At the end of the second quarter, over 98% of AGNC's portfolio was in agency MBS, with over 97% of its agency portfolio in 30-year fixed mortgages. Annaly, meanwhile, had 88% of its portfolio in agency MBS. About 94% of its agency portfolio was in 30-year fixed MBS.
In its filings, AGNC has indicated that, based on its portfolio at the end of June, a 25-basis-point narrowing in the MBS-to-Treasury spread would have a 12.6% positive impact on its book value, while a 50-basis-point narrowing would have an over 25% positive impact. This is a bit more of a benefit than Annaly would see.
Annaly said that, based on a 15-basis-point narrowing, its book value would improve by 6.2%, while with a 25-basis-point improvement, its book value would see a 10.4% boost.
AGNC stock is the slightly more expensive of the two, trading at 1.23 times book value compared to 1.06 times for Annaly. AGNC carries a 13.9% yield, while Annaly has a 12.7% yield.
While they have some slight differences, both stocks are set to greatly benefit from the Fed rate cut cycle and the likely narrowing of the MBS-to-Treasury spread. Both stocks carry robust yields well over 12% and should see their book values improve, leading to both strong dividend returns as well as nice stock appreciation over the next few years as interest rates begin to move downward. As such, I'd be a buyer of both stocks.
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SVB Financial provides credit and banking services to The Motley Fool. Geoffrey Seiler has positions in Annaly Capital Management. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy .
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