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Yields on agency mortgage-backed securities are rising again after bottoming out last Fall
This chart shows the yield on newly-issued Fannie Mae mortgage backed securities. This is not the rate the borrower pays, rather it is the yield that the ultimate lender receives. The difference between the two is the compensation to the servicer and the originator. The average rate for a 30 year fixed rate mortgage is currently 3.57%. The yield to the investor is approximately 100 basis points less. For a mortgage REIT, which invests in agency mortgage backed securities, this is the rate they focus on most.
REITs invest primarily in agency paper focused on conforming (a.k.a. Fannie Mae or Freddie Mac) mortgage backed securities and government securities (Ginnie Mae). Ginnie Mae securities are backed by the full faith and credit of the U.S. government; Fannie Mae securities are not. For this reason, Ginnie Mae mortgage backed securities trade at lower yields than Fannie Mae securities.
The question on everyone’s mind: when does quantitative easing end?
Mortgage backed securities tend to correlate strongly with the 10-year Treasury rate. The market maintains a risk-based spread to Treasuries and they tend to move in lockstep. However, this relationship is being affected by quantitative easing by the Federal Reserve. The Fed is buying 40 billion of MBS per month in an attempt to help consumers refinance into more affordable mortgages. The question on everyone’s mind is, “When will this end?”
The minutes from the Federal Open Market Committee meeting seemed to suggest that members were leaning towards ending quantitative easing (QE) sometime this year. Ben Bernake subsequently threw cold water on that idea while testifying in front of the Senate Banking Committee. While the Fed has been very direct in discussing when the era of ultra-low interest rates will end, they have been more opaque about the end of QE.
Rising rates: a double-edged sword for mortgage REITs
The end of quantitative easing will definitely challenge the agency REITs. Readers may look at the chart above and ask how a REIT can pay a dividend yield of double digits while investing in securities that yield 2.5%. The answer to that question is leverage. REITs will typically lever 4x to 6x, meaning they will take $100 million of equity and purchase $500 million worth of mortgage backed securities, borrowing $400 million. This has the effect of increasing both the return and risk.
Once rates increase, REITs will be able to re-invest in higher yielding mortgage backed securities, but they face mark-to-market losses on their existing bonds. While they are able to hedge this using interest rate derivatives, hedges are imperfect and liquidity risk looms large. Investors will want to stick with REITs that are hedging their interest rate risk and are less levered once rates start backing up.
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