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Why Mortgage REITs Deserve Some Love in 2014

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There's nothing sexy about mortgage real estate investment trusts. They can't talk to you like Siri or deliver packages with drones like Amazon envisions. But they currently yield 13 percent while Treasury bonds yield only 3.8 percent.

The fact that they're boring and complicated wasn't the only reason investors ignored mortgage REITs in 2013, though it sure didn't help. These hybrid securities, which invest primarily in mortgage bonds but trade like stocks, lost 3 percent on average even after factoring in double-digit dividend yields. The S&P 500, meanwhile, was up 30 percent.

Michael Widner, a REIT analyst at KBW Bank, says the sector is poised to deliver returns over 20 percent this year. Aside from the high dividend yields, the average mortgage REIT now trades at a 20 percent discount to the book value of its underlying bond portfolio, he says. Widner expects that 20 percent-plus return to come from half of the current discount going away, in combination with the REITs' generous yield. He's less sanguine about the stock market. “I have a difficult time seeing the broader market replicating its 2013 returns in 2014,” he says.

The biggest mortgage REIT is Annaly Capital Management Inc. (NLY ), which has a market capitalization of $9.7 billion. Some investors favor it as a good play on the entire industry. “The management team is more seasoned than teams at most other mortgage REITs,” says David Cohen, manager of the Eudora Fund (EUDFX ), which has 4.4 percent of its assets in Annaly. The stock has an 11.5 percent dividend yield.

The Real Rate Story

The worry about mortgage REITs is and has been rising interest rates, because as they rise, bond prices fall. A rise in rates has hurt the bond holdings of some REITs, which have pared some bonds, increased their hedging and cut dividends. Cohen isn’t too concerned about higher rates. For one thing, mortgage REITs aren’t really bond funds, but are businesses that can and do use complex hedging strategies to protect themselves from rate increases. In Annaly’s case, about half of its portfolio is hedged, Cohen says.

Moreover, no single interest rate determines a mortgage REIT’s profitability. Instead, it's the gap, or spread, between long-term rates and short-term ones. REITs borrow money based on short-term rates and use that money to buy long-term bonds. The greater the gap between short-term borrowing rates and what long-term bonds are yielding, the more profitable a mortgage REIT will be. With the rate on 3-month Treasuries at 0.07 percent and 10-year Treasury notes at 2.90 percent, the spread between the two has almost never been wider in the last 35 years, Cohen says. So the profit margins of mortgage REITs are particularly fat.

If the

Federal Reserve raises short-term interest rates, that gap could shrink. Chairman Ben Bernanke has shown no interest in doing that until the economy is on a much sounder footing. So far the Fed has decided to reduce its monthly bond purchases to $75 billion from $85 billion, which should affect only long-term yields. Current Vice Chairman Janet Yellen. who takes over the top spot on Feb. 1, is committed to more of the same. At her recent Senate confirmation hearing she stated: "We have made good progress, but we have farther to go to regain the ground lost in the crisis and the recession."

Any rise in long-term rates that results from the Fed lessening purchases of mortgage bonds would actually increase the yield spreads mortgage REITs can earn. Homeowners tend to pre-pay their mortgages when rates are low, which hurts mortgage-bond investor returns. Rising long-term rates discourage such refinancings, as the cost to refinance a home with a new mortgage rises.

Small-Cap REITs

While Annaly has a decent yield, KBW's Widner isn't a fan. He says it has been “substantially under-earning its dividend.” In the fourth quarter, Annaly cut its dividend from 35 cents to 30 cents. Widner estimates it's earning only 20 cents and says more cuts may be on the horizon. That's because the company has been deleveraging to reduce its interest rate risk. Also, the cost of hedging reduces profits. Such a conservative approach may appeal to long-term investors nervous about potential rate increases.

Widner prefers smaller mortgage REITs like Hatteras Financial Corp. (HTS ), which has a $1.7 billion market cap and an 11.4 percent yield. The company’s stock has historically traded above its book value, and now trades at a 18 percent discount. Its portfolio is largely hedged and primarily consists of adjustable-rate mortgages that won't suffer as much as fixed-rate bonds in a rising-rate environment.

Hatteras and Annaly invest in the highest-quality mortgage bonds, known as agency mortgage bonds. Widner also likes two small-cap REITs -- American Capital Mortgage Investment Corp. (MTGE ) and AG Mortgage Investment Trust Inc. (MITT ) -- that invest in higher-yielding mortgage bonds of lower quality. Both trade at about 15 percent discounts to their book values and have dividend yields that top 14 percent. They're largely hedged against rising rates.

For investors who prefer funds to stocks, there’s an exchange-traded fund that invests in mortgage REITs -- the iShares Mortgage Real Estate Capped fund (REM ). Owning it may make less sense than buying one of these REITs directly. It has 15.2 percent of its assets in Annaly and 12.5 percent in another dominant player, American Capital Agency Corp. (AGNC ). So if you don’t like those two stocks, it’s not worth owning. Right now better opportunities may lie in the small fry.

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