Mortgage real estate investment trusts (REITs) took a beating in 2013 when the eventual end of qualitative easing became a reality and tapering was announced, and while they have partially recovered since the beginning of this year (some are now at 52-week highs) Sterne Agee analysts Jason Weaver, Henry Coffey Jr., and Calvin Hotrum argue that they are still attractive at their current prices.
“Price/Book ratios remain well south of their historical medians even in comparable periods of heightened interest rate volatility, and dividend yields now appear far more sustainable and attractive versus comparable asset classes,” they write. They specifically like Buy-rated Two Harbors Investment Corp (NYSE:TWO) and MFA Financial, Inc. (NYSE:MFA).
Mortgage REITs: Tapering somewhat offset by lower MBS supply
Most investors are worried about mortgage REITs because of the effect of tapering and the eventual rise in policy rates, but the sharp drop in prices last year was in reaction to that news and Weaver et al think that investors overstate the real impact on mortgage-backed security (MBS) spreads. Even though the Fed is reducing its total MBS purchases, the supply of MBS has fallen along with slow refinancing activity (most homeowners have already taken advantage of rock bottom rates if they were ever going to) and fewer home purchases. The Sterne Agee report argues that the lower supply and the Fed’s continued policy of reinvesting MBS principal paydowns slightly offset tapering, but the market isn’t taking these factors into account.
Mortgage REITs: Interest rate risk muted by slack in the labor market
Their other argument is that a sharp rise in interest rates is less likely than the market imagines because there is still slack in the labor market, especially when measured by underemployment and labor force participation.
While a falling labor force participation rate is sometimes a sign that people have given up looking for work or passed time in grad school instead of unemployment (and that’s part of the issue now), it is also one of the effects of an aging and retiring baby boomers. This demographic shift was evident well before the financial crisis, and it’s hard to see why Federal Reserve Chair Janet Yellen would be particularly swayed by this trend.
On the other hand Yellen has been focused on underemployment, which continues to be a major problem. U-6 unemployment/underemployment is still at 12.1%, the highest level in more than 20 years. There has been some mixed guidance about when the market should expect rates to go up, but as long as underemployment is this high Yellen is unlikely to raise rates quickly.