Ginnie Mae securities rally to 106 10/32, affecting REITs

Market Realist

Must-know outlook for homebuilders and REITs like Annaly (Part 6 of 6)

(Continued from Part 5)

Ginnie Mae TBAs represent the mortgage-backed security for government mortgage loans

While Fannie Mae TBAs represent the usual conforming loan—the plain vanilla Fannie Mae 30-year mortgage—Ginnie Mae TBAs are where the government loans like FHA and VA loans go. The biggest difference between a Fannie Mae MBS and a Ginnie Mae MBS is that Ginnies have an explicit guarantee from the Federal government. Fannies do not, although there is a “wink wink, nudge nudge” guarantee. As a result, Ginnie Mae MBS trade at a premium to Fannie Mae TBAs.

There are also two different Ginnie Mae TBAs: Ginnie 1s and Ginnie 2s. Ginnie 1 TBAs include mortgages with the exact same coupon payment. Ginnie 2 TBAs can include a variety of coupons within a range. Because the investor can have more certainty with Ginnie 1s compared to the 2s, the 1s typically trade at a premium. This premium can vary, and you’ll often see investors switch between 1s and 2s as a relative value trade. The Ginnie Mae 1s tend to be more liquid than the 2s and have narrower bid-to-ask spreads.

Ginnie Mae MBS rally with the bond market

The front-month Ginnie Mae TBAs worked their way higher as bonds rallied on weak economic data. After starting the week at 106 2/32, they picked up about a quarter of a point to finish the week at 106 10/32.

Implications for mortgage REITs

Mortgage REITs—like Annaly Capital (NLY), American Capital (AGNC), MFA Financial (MFA), and Capstead Mortgage (CMO)—announced big drops in book value per share, as rising rates hurt the value of their mortgage-backed security holdings. The REIT sector spent most of 2013 deleveraging to position itself for increases in rates.

As a general rule, a lack of volatility is good for mortgage REITs and the mortgage REIT ETF (MORT) because they hedge some of their interest rate risk. Increasing volatility in interest rates increases the cost of hedging. This is because as interest rates rise, the expected maturity of the bond increases, as there will be fewer pre-payments. On the other hand, if interest rates fall, the maturity shortens due to higher pre-payment risks. Mechanically, this means mortgage REITs must adjust their hedges and buy more protection when prices are high and sell more protection when prices are low. This “buy-high, sell low” effect is called “negative convexity,” and it explains why Ginnie Mae MBS yield so much more than Treasuries, which have an identical credit risk (which is to say none). Investors who want to make directional bets on Treasuries should look at the iShares 20-year bond ETF (TLT).

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