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Capstead Mortgage (CMO) weathers the bond market sell-off well

Capstead Mortgage is a Dallas-based mortgage REIT focusing on agency adjustable rate mortgages

Capstead Mortgage (CMO) is a REIT that focuses on seasoned agency adjustable-rate mortgages (ARMs). In other words, it purchases mortgages that have a fixed rate for the early years of the loan—say three, five, or seven years—and then adjusts its rate as interest rates change. Because it invests in agency paper (mortgages insured by the government-sponsored entities Fannie Mae, Freddie Mac, or Ginnie Mae), it bears very little credit risk. Because it doesn’t buy new paper, the duration of its portfolio is much lower than most. Most of its risk is interest rate risk. As a real estate investment trust, it must pay out 90% of its earnings as dividends and isn’t subject to corporate taxes.

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Highlights of the quarter

The mortgage REIT space has been pummeled as rates started rising on the prospect of the withdrawal of quantitative easing. Capstead’s book value per share fell to $12.80 versus $13.60 the prior quarter—a drop of 6%. Some of that decline was due to a preferred stock issue, so its portfolio book value really only declined 3.8%. Other REITs have experienced drops of 20%. This is because Capstead focuses on short-duration ARMs in the agency space as opposed to fixed-rate mortgages or even the longer-dated ARMs (like 7/1 ARMS).

Capstead didn’t sell any securities during the quarter, and it ended with a leverage ratio of 8.4. The vast majority of its portfolio was originated prior to 2008, which means it had very little interest rate risk. That said, it would still face liquidity risk. Prepays did increase during the quarter, as floating borrowers undoubtedly noted the increase in interest rates and chose to refinance into a 30-year fixed-rate mortgage.

Read-across to the other mortgage REITs

Every mortgage REIT has different exposure. This quarter, Capstead’s focus on purchasing short-duration adjustable rate securities has helped it. Agency ARM REIT Hatteras (HTS) experienced a 20% decrease in book value, primarily because it focuses on the longer-duration ARMS. (Remember, the higher the duration, the higher the interest rate risk.) REITs like Annaly (NLY) and American Capital (AGNC) have 30-year fixed-rate exposure and would therefore experience bigger hits to their book values.

As laid out in the REIT earnings strategy guide, as far as agency REITs go, Capstead probably has the right strategy for a rising interest rate environment. That said, non-agency REITs may also experience lower declines in book value, as credit is improving even as interest rates rise.