Real estate investment trusts — REITs — are a specific type of company which are both taxed and structured uniquely. Because they give most of their profits in the form of dividends to avoid higher taxes, REITs are popular with retirees and income seekers, but many popular finance journalists have warned of the danger of these volatile and complex investments. Investors should buy them not for the dividend income, they say, but for the fundamental value of the companies themselves.
This advice is mostly true, but a lot of profits were on the table for short-term investments in REITs, especially in 2010 and 2011 when they offered high dividend yields and held or increased their pricing at a time of flat to declining equity markets. The love of REITs did not stop in 2012 when income-seeking trends caused an appreciation of bonds
Here we are going to look at the performance of REITs that borrow at bond rates and buy up mortgage-backed securities (MBS). These companies, known as mREITs, profit from the spread between short-term and long-term bond rates, so are specifically sensitive to changes in the bond market. And since a lot of attention has gone to rising bond yields, panic selling has resulted in several mREITs falling to 52-week lows.
The Bond Woes
Two recent macroeconomic developments have hit the mREITs particularly hard. Firstly, long-term bond rates are rising, which could signal a rise in short-term bond rates and thus pressure on mREITs’ profitability, since they depend on a wide spread between the two to make money. Additionally and importantly, a strengthening economy means more early mortgage repayments, which is bad for mREITs that depend on interest payments on mortgages to make money.
The second macroeconomic development to hit the mREITs has been the U.S. government’s bond-buying activities, which was concentrated on mortgage-backed securities and put, in theory, a price floor on the securities and greater competition in the bond-buying market. While this is a very technical development whose impact on mREITs was unclear when it started late last year, falling profits (or even losses, in some cases) have demonstrated that this extra government competition has hurt these companies profitability.
Now, mREITs are going down as investors worry that rising bond rates will diminish or eradicate these companies’ profit margins. Thus as bond yields go up, mREIT stocks have gone down.
A Fall and Recovery
For this example, I am using the performance of American Capital Agency Corp. (AGNC), but the pattern held true for most of the mREITs, particularly those that specialize in government-backed mortgages.
A quick look at AGNC’s performance on Wednesday reveals a lot:
Here, we see an early-day sell-off as investors worry that bond yields are rising and a recovering economy will hurt AGNC’s value. The stock peaked in the morning at its 90 day SMA only to fall nearly 5% below its 90 day SMA within an hour. Such a precipitous crash inevitably leads to a bottom, as we saw around 11am and a recovery. The stock closed slightly up as a well-timed market correction brought AGNC into the green.
On Thursday, intraday trading for AGNC has been overwhelmingly positive, with the stock surging to a peak of 2% appreciation and settling on a rise of about 1.5% by lunchtime.
For those who bought into AGNC at the lowest point on Monday, big short-term profits are on the table. Alternatively, long-term high yields are possible, too. The sell-off on Wednesday resulted in the classic U-shaped chart of panic selling; fears about bond growth hit fever pitch in the financial media, causing the stock to crash. Seeing an arbitrage opportunity at best or a high yield on cost opportunity at worst, momentum traders swooped in and resulted in a tidy profit.