Recommendation: REITs are getting bullish—should you?

Market Realist

REITs are getting bullish as bonds rally on tensions: Should you? (Part 7 of 7)

(Continued from Part 6)

REITs had a very rough 2013

2013 was a very difficult year for mortgage REITs, as the Fed finally began to lighten its footprint in the mortgage market by reducing asset purchases. Starting May 2013, the big REITs like Annaly (NLY) and American Capital Agency (AGNC) basically lost a third of their market cap because the underlying value of their portfolios fell as interest rates rose. The ten-year bond yield steadily increased from about 1.6% to 3%, and the whole sector was demolished. REITs were forced to de-leverage in a difficult environment and their book values suffered accordingly. Dividends were slashed.

Interesting tidbits from earnings reports

Over the last few weeks, we heard from the biggest Agency REITs—Annaly and American Capital Agency. Both seemed to think that the sell-off was overdone and were making bets on the sector. While these stocks are primarily thought of as agency REITs, in that they primarily invest in government-guaranteed MBS, they’re allowed some freedom to invest outside that box. American Capital Agency began buying stock in its competitors. That is a very interesting bet—a bet that the whole mortgage REIT sector is undervalued.

Annaly announced earnings last week and said that it plans to increase exposure in the mortgage-backed security (or MBS) space and bring its leverage ratios from 5x to closer to 7x. Again, this is a punchy bet on MBS, and it takes their leverage ratio to a higher level than prior to the big selloff that began in 2013. Interestingly, Annaly isn’t buying its own stock.

Should you follow Annaly’s lead?

Bonds seem to be trading in a range right now of 2.5% to 3%. The important thing to remember is that while the Fed is decreasing its purchases of MBS and more or less seems committed to exiting quantitative easing by this fall, short-term rates are probably going nowhere. If anything, the body language out of the Fed seems to be backing off from the unemployment rate target it was using for a trigger to begin raising the Fed funds rate. For the REITs, the thing to focus on is their interest rate spread and the fact that the yield curve has steepened. If the value of their MBS has found a level here, then a lot of the risk has been taken off the table. Of course, there’s an implied directional bet on the bond market here, which is that bonds will stay in this trading range. If you want to make a bet on credit risk, you can look at non-agency REITs like Two Harbors (TWO). An alternative way to make directional bets on the bond market would be through the Treasury ETF (TLT). Conversely, you can buy the entire sector through the Market Vectors Mortgage REIT (MORT).

To learn more about investing in REITs, see the Market Realist series Annaly Capital’s 4th quarter 2013 earnings: Must-know takeaways.

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