Some possible scenarios
Scenario 1: The economy is beginning to slow and it appears we’ll be heading into a recession
This scenario is one where you’ll be worried about increasing credit risk, and you’ll most likely see rates start to fall, as the Fed eases. In this scenario, you want long duration. Agency REITs that focus on 30-year fixed-rate mortgages will outperform, as they have the highest exposure to interest rates. Steer clear of non-agency REITs, which will see an increase in delinquencies.
Scenario 2: The economy is expanding and we’re starting to see inflation
Increases in inflation generally mean increasing short-term and long-term interest rates. Increases in short-term rates affect the borrowing rates for REITs, and the increase in long-term rates is generally negative for 30-year fixed-rate mortgage-backed securities. In this situation, you want to be in adjustable-rate agency REITs. Why? Because the yield on their mortgage-backed securities increases as short-term rates increase. These REITs will have much less interest rate risk, and therefore they have less mark-to-market risk.
Scenario 3: The economy is rapidly recovering from a recession and starting to take off
This scenario would be associated with easing credit, investors being more comfortable with taking risk (the risk-on trade), and increasing interest rates. Given that interest rates are increasing, you’d want to minimize your interest rate risk. Because the economy is expanding, you’d want exposure to improving credit profiles. This means you want non-agency REITs—especially ones that tend to invest in the lower tier of credit, where tightening credit spreads can offset the effect of increasing interest rates. These companies usually have origination businesses, which generate fee income as mortgage applications rise.
How to decide
You should base your choice of mortgage REIT on your risk tolerance and also your top-down macro view of the economy. As we’ve seen since rates started going up, you can make (or lose) a lot of money at inflection points, where the story changes.
This analysis continues in Recommendation: Think about upcoming mortgage REIT earnings (Part 4).
© 2013 Market Realist, Inc.