Prepayment speeds are a key driver of REIT returns
Prepayment risk refers to borrowers being allowed to refinance their mortgages without penalty. This means that as rates fall, REITs find their mortgage-backed securities (or MBS) paying off early, and they’re forced to reinvest that money at lower rates. Prepayment risk is a fact of life even in rising interest rate environments. After all, even if rates are rising, people still move. However, the speed of prepayments tends to fall. In falling interest rate environments, prepayment speeds and assumptions are huge drivers of MBS returns.
The taper tantrum was supposed to mark the end of prepay worries
In mid-2013, after the Fed hinted that QE (quantitative easing) days were numbered, long-term rates began to increase. Rates rose from about 1.6% to close to 3% by the end of the year. This ended the big refinance (or refi) boom. While refinances have continued, they were mainly driven by home price appreciation and not interest rates. Now that interest rates are falling again, do the REITs need to fear another refi wave? As you can see from the chart, it looks like the MBA refinance index is still flat on its back. So while we could see a pickup in refis, so far it hasn’t materialized.
Effect on REITs
Increasing prepayment speeds will have more of an effect on mortgage REITs that are concentrated in 30-year agency fixed-rate MBSs such as Annaly Capital Management (NLY) and American Capital Agency (AGNC). REITs that are more focused on adjustable rate mortgages, such as MFA Financial (MFA), Capstead Mortgage (CMO), and Hatteras Financial (HTS), are less vulnerable. REITs with a focus on 30-year fixed-rate mortgages usually use a lot of leverage and therefore have less margin for error in hedging their portfolios.