World Stock Watch

Mortgage REITs: A Shift in the Macro Environment

The mortgage REIT (mREIT) sector has historically been plagued by book value erosion, primarily due to shocks to the financial system and unfavorable macro conditions. As a result, we have generally avoided investing in common shares of mREITs, opting instead for preferred shares. However, recent changes in the macro environment have improved the outlook for mREITs, making them more attractive to investors.

Four Positive Changes in the Macro Environment

There are four significant positive changes in the macro environment that are benefiting mREITs:

1. Decreasing RMBS Spreads: Residential Mortgage Backed Security (RMBS) yields are correlated with Treasury yields, but the premium over Treasuries at which they trade is variable. Recently, RMBS spreads have decreased, resulting in higher prices for existing RMBS holdings.
2. Reduced Negative Convexity: RMBS trading at a premium to par can experience negative convexity, where price movements are unfavorable regardless of yield changes. However, with most mortgages currently outstanding trading at a discount to par, this risk is mitigated.
3. Lower Repo Rates: Repo rates have decreased, reducing the cost of capital for mREITs and improving spreads on investments.
4. Uninversion of the Yield Curve: The yield curve has uninverted, allowing mREITs to earn positive carry from the yield curve, a powerful source of forward returns.

Investment Implications

Given these positive changes in the macro environment, we are revising our investment strategy for mREITs. While we still do not consider mREITs a great asset class in general, the improved environment makes them more attractive. We would now consider investing in moderate discounts, whereas previously we required extreme discounts.

Preferred Shares Remain Attractive

mREIT preferred shares remain good investments, offering strong underlying company fundamentals and attractive yields. We continue to like Arbor Realty Trust, Inc. (ABR) preferreds, Chimera Investment Corporation (CIM) preferreds, and a few others that can be purchased opportunistically.

Conclusion

The shift in the macro environment has improved the outlook for mREITs, making them more attractive to investors. While we still approach the sector with caution, we believe that moderate discounts can offer attractive investment opportunities. Preferred shares remain a good option for investors seeking strong yields and relatively lower risk.