MFA Financial bears credit risk as well as interest rate risk
When people typically think of mortgage REITs, they inevitably think of the giant agency REITs like Annaly Capital (NLY) and American Capital Agency (AGNC). These REITs are heavily exposed to agency mortgage-backed securities, which means the US government guarantees the principal and interest. This guarantee means these REITs bear no credit risk. In essence, they’ve swapped credit risk for interest rate risk.
Note that some mortgage REITs, like Capstead Mortgage (CMO) and Hatteras (HTS), invest in agency adjustable-rate securities. They have less interest rate risk and bear no credit risk. Investors interested in trading the REIT sector as a whole should look at the iShares Mortgage Real Estate Capped ETF (REM).
MFA Financial (MFA) invests heavily in non-performing and re-performing mortgage-backed securities. Non-performing mortgage-backed securities contain mortgages that are currently not paying interest and are being worked out with the servicer. They make their returns as the mortgages underlying the loan are either modified or the home is foreclosed upon. MFA invests in the senior tranches of these loans, which means they have some credit protection in the form of subordination and lock-outs. Subordination and lock-outs are ways that bankers enhance the credit of senior tranches of MBS (mortgage-backed securities). It basically means that the senior tranches have to be paid first, and anything leftover gets allocated to the junior tranches. MFA sticks to the senior tranches.
To understand the difference between the two types of MBS, consider that Annaly might be buying a Fannie Mae 30-year MBS for 104, knowing that eventually it will receive 100 for it. However, it will get interest in the meantime. These bonds are highly sensitive to interest rates because of varying prepayment speeds. On the other end of the spectrum, MFA might buy a non-performing MBS pool for 77 cents on the dollar and hope to get 100 for it as the underlying mortgages are modified or foreclosed. The interest rate risk to these sorts of MBS tends to be low, or at least much lower than 30-year fixed-rate MBS.
MFA Financial has been increasing its book of non-performing and re-performing MBS and, as a result, it’s much better positioned for a rising interest rate environment. Investors interested in making directional bets on interest rates should look at the iShares 20+ Year Treasury Bond ETF (TLT).