Last year was a struggle for the entire mortgage real estate investment trust (REIT) sector. The Federal Reserve hiked rates aggressively in order to quell inflation, which killed the mortgage refinancing market and put several mortgage bankers out of business. Second, the rise in interest rates caused mortgage-backed securities (MBS) to lose money and pushed many mortgage REITs to cut their dividends. The pain continues in the sector, but MBS seem cheap compared to historical levels. Are the mortgage REITs a buy, and if so, which ones?
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AGNC Investment is the classic agency mortgage REIT
AGNC Investment(NASDAQ: AGNC) is an agency mortgage REIT, which means it concentrates on mortgage-backed securities which are guaranteed by the U.S. government. If you recently took out a mortgage guaranteed by Fannie Mae or Freddie Mac, your loan was probably securitized and ended up in a mortgage-backed security which is similar to the sort of bonds that AGNC owns.
These bonds have no credit risk -- if the borrower misses a payment, the mortgage servicer or Fannie Mae will ensure the bondholder gets their monthly principal and interest payment. However, as we saw in Silicon Valley Bank's liquidity crisis, mortgage-backed securities can still lose value due when interest rates rise. Government-guaranteed does not equate to risk-free.
Non-agency mortgage REITs invest in mortgages that are not guaranteed by the government. These securities generally pay higher rates, but if the borrower doesn't pay, the investor can lose money. Annaly Capital Management (NYSE: NLY) invests primarily in agency mortgage-backed securities, but it does have a credit portfolio as well.
Mortgage REITs have struggled over the past year
Ever since the Federal Reserve began hiking the benchmark federal funds rate in order to beat inflation, mortgage-backed securities have fallen in value. This caused big declines in book value per share for AGNC and Annaly over the past year. That said, mortgage REITs have highly attractive dividend yields, so it makes sense for investors to want to take a look.
Just about every mortgage REIT was forced to cut its dividend, and AGNC Investment is the last holdout. Annaly recently cut its dividend earlier this year. Investors who are attracted to the high yields of the mortgage REIT spaces should understand that these stocks are highly speculative until the Fed stops hiking rates. An end to the Fed tightening cycle would be a good catalyst for entry. Mortgage-backed securities (which are the core asset of both companies) have underperformed Treasuries given the volatility in the bond market, and once the Fed wraps up its tightening cycle, we could see a long period of mortgage-backed securities outperform versus Treasuries. This would imply rising book value per share as mortgage-backed securities get more valuable.
That said, sentiment will probably remain awful in the mortgage REIT space until the Fed begins cutting rates. The timing is not right quite yet, because mortgage REITs are one of the key asset classes where the old saying "don't fight the Fed" is applicable. Once the Fed signals a pause in rate hikes, it might make a good entry point for investors. While a Fed pause is positive for both Annaly and AGNC, a recession is not. We are seeing declining real estate prices as well and a potential recession would imply greater risk for Annaly. AGNC is the safer bet in that circumstance.
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Brent Nyitray, CFA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
