This is a guest contribution by Tom Hutchinson, Chief Analyst, Cabot Dividend Investor and Cabot Income Advisor
The coronavirus might be getting worse right now, but Wall Street doesn’t care. The market tends to look ahead about six months or so into the future. By then, it sees a booming economy, low interest rates and an economy drowning in government stimulus. Just when the vaccine rally was starting to run out of gas, stimulus hope is reviving the euphoria.
The results of the recent election create the perception that there will be more government stimulus. And the market loves stimulus. While Wall Street types may look ahead six months, they don’t look any further than that. They live and breathe in the near future only. Telling them about something that will happen in two or three years is like telling them about the year 2046. They don’t know if they’ll still be alive by then. Government stimulus and interest rate cuts are the best things that happen to them in this life.
Say what you will about the current environment. But one thing is clear: It’s good for mortgage REITs.
Mortgage REIT Overview
While typical REITs own actual physical real estate properties, charge rent, and pass that income onto shareholders, mortgage REITs are much different. These companies buy mortgages and generate income from monthly mortgage payments. A mortgage REIT borrows money at low short-term rates and uses that money to buy mortgages that pay a higher interest rate, making a profit on the difference in rates, or the net interest spread.
Mortgage REITs are not good investments to buy and forget about. In fact, the long-term returns of mortgage REITs are generally poor. There are good times and bad times to own mortgage REITs. I believe now is a very good time–here’s why.
It’s all about the Spread
There are different kinds of mortgage REITs. Some invest in government-backed mortgages; others invest in riskier securities. Some do a good job of managing the balance sheet while others have weaker balance sheets. But interest rate spreads are the most important thing by far. The difference between long- and short-term rates is what drives these stocks higher or lower.
Short-term rates are as low as they can be while longer-term rates are rising. The Fed cut the benchmark Fed Funds rate to between 0% and 0.25% when the pandemic emerged. It has pledged to keep these rates there for a long time. The central bank has a lot of control over short-term rates but much less over longer-term rates. And a full recovery in an economy drowning is stimulus is certain to put upward pressure on these longer-term rates.
In fact, it’s already happening. The 10-year treasury rate, a benchmark for longer-term rates including mortgages, is already on the rise. It has more than doubled from the low of 0.50% in the midst of the bear market to 1.1% today. A full recovery and easy money is bound to drive rates higher during this year. There’s plenty of upside: The 10-year treasury rate was over 3% before all this nonsense.
A rising spread is the whole ball game for these securities. When the spread between long and short rates increases, so does the profitability and stock prices of mortgage REITs, and vice versa. It’s really all that matters. But there are additional considerations as well.
Low Prices
Prices fell sharply in the pandemic bear market, as interest rates crashed and credit concerns dragged the sector down. The sector crashed more than 50% in a little over a month during the tumult. But the situation has vastly improved since, as spreads have risen and the economy has strongly recovered. But these securities are still miles from the pre-pandemic highs while the environment is shaping up to be far better than the pre-pandemic environment.
Yields are Obscene
It’s tough to find income in this low interest rate world. But mortgage REITs are yielding 9% and 10% or higher. That may seem too good to be true, and usually it is. But this unique environment creates a situation where you can actually get a yield that high, and a good chance of a rising stock price to boot. It’s a yield opportunity that hasn’t existed in a decade.
Which mortgage REITs should you buy? I would stick with the biggest and the best, which include AGNC Investment Corp. (AGNC) and Annaly Capital Management (NLY). These securities yield a whopping 9.3% and 10.7%, respectively.
AGNC has the more conservative portfolio of mortgages, with almost the whole portfolio in government agency backed securities, as well as the better track record. Annaly has a better balance sheet with less leverage and a higher yield. But either one is a good investment right now and should deliver a phenomenal yield, and likely capital appreciation as well in the next year.
