Investing in REITs during a rising interest rate environment

Market Realist

A must-know guide to Annaly Capital's 1Q14 earnings (Part 5 of 5)

(Continued from Part 4)

The secular bull market in bonds is over

Mortgage REIT investors have finally received a taste of what interest rate risk looks like over the past year. For most of the past 30 years, bonds have been a one-way bet, with rates generally falling from high tens to zero. Investors have mainly had to worry about prepayment risk, but they haven’t experienced a protracted bear market in bonds. Take a look at the chart below. Interest rate cycles are long. We may see the occasional cyclical bond bull markets in the context of a secular bear market, but the overall trend is toward increasing interest rates.

Interestingly, the last cyclical bear market in bonds was in 1994, and it blew up a number of leveraged mortgage-backed securities investors—namely, hedge fund Askin Capital Management and Orange County. Mortgage REITs like American Capital Agency (AGNC), Annaly (NLY), Hatteras (HTS), Capstead (CMO), and MFA Financial (MFA) are sophisticated MBS investors, but as the financial crisis showed us, sometimes even the smart guys can get taken out when there’s blood in the water.

Not all mortgage REITs are alike

Mortgage REITs have different exposures. For example, a REIT like Annaly or American Capital Agency is primarily invested in fixed-rate mortgage-backed securities, and they will have a different risk profile than a REIT like MFA, Hatteras, or Capstead, which invest in ARM MBS. Similarly, non-agency REITs like Newcastle take on credit risk, which means they have higher nominal yields and so use less leverage.

As a general rule, increasing interest rates will raise the cost of financing the REIT balance sheet and will cause mark-to-market losses on their investment portfolio. New securities will have higher yields, which means any runoff can be reinvested in higher yielding securities. But generally, an increasing interest rate environment is difficult for REITs. At some point, interest rates will start increasing. However, for the time being, they’re in a much better position than they were a year ago, with fatter net interest margins. If short-term and long-term interest rates stay the same for a couple of years, REITs will pay decent dividends. But as a REIT investor, understand that you’re fighting the tape.

To learn more about important mortgage real estate investment trusts like Annaly, see Market Realist’s Mortgage REITs page.

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