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Watching for mREITs to reduce leverage

| March 13, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Recent sharp moves to lower rates and wider spreads have likely put pressure on a wide range of mortgage REITs to reduce balance sheet leverage. mREIT asset value has likely lagged hedges, cutting into capital and driving the deleveraging. The sector looks most likely to sell assets in the near term, putting pressure on a range of mortgage spreads. But wide spreads also create attractive potential leveraged returns, so sales may be followed eventually by efforts to raise capital.

mREIT exposure to changing rates and spreads

Disclosures of balance sheet market sensitivity at the end of the fourth quarter 2019 suggest mREITs had a range of interest rate exposures but consistently higher exposure to spreads (Exhibit 1). Among selected mREITs disclosing sensitivity, the projected change in net portfolio market value for a 50 bp drop in rates, for example, ranged from a 0.1% loss in REIT B to a 0.8% gain in REIT D. Projected impact on balance sheet equity for a 50 bp drop ranged from a 0.9% loss in REIT B to a 6.8% gain in REIT D. The larger effect on equity reflects each firm’s leverage. For a 25 bp widening in spreads, however, change in net portfolio value came in consistently around a loss of 1.2%. Change in equity, however, ranged from a loss of 10.2% in REIT A to 14.0% in REIT B.

Exhibit 1: Reported market sensitivity of selected mREITs

Note: *Reported for moves of 20 bp to 50 bp. Source: Company 4Q2019 investor presentations.

These and other mREITs have had to manage through a 100 bp drop in most Treasury rates since the start of January and a 50 bp widening in 30-year MBS OAS (Exhibit 2). mREIT quarterly estimates of market exposure usually assume an instantaneous shift in rates or spreads with everything else held constant. In reality, most portfolios continually shift the mix of assets and hedges, so actual results could differ significantly. Nevertheless, mREITs’ leveraged exposure to asset spreads almost certainly hit equity. For mREITs to maintain leverage targets, they are likely to sell assets.

Exhibit 2: REITs this year have had to manage sharp moves in rates and spreads

Source: Bloomberg, Amherst Pierpont Securities

Trading desks in March have reported steady orderly selling of pass-throughs from mREITs, with most flow coming in 30-year specified pools. Funding desks have reported orderly financing.

Wider mortgage spreads should create attractive opportunities for mREITs to generate leveraged returns. Decisions to raise equity, however, will depend on where REITs mark their books at the end of March and the market price of their equity. REITs tend to issue only if the market price of equity, net of issuance costs, is higher than book value.

REIT leverage and risk management

The recent market pressure on mREITs stems from the business model of holding a leveraged, hedged portfolio of MBS and mortgage loans. mREITs hedge some portion of their interest rate and spread risk. But hedging reduces income, and REITs expected by equity investors to produce dividends of 10% or more over the last few years often leave some risk unhedged.

A typical REIT hedges interest rate risk by paying the fixed rate on a swap or by selling Treasury or swap futures. When rates fall and negatively convex assets trade to steadily shorter durations, the typically positively convex hedges trade to longer durations. Maintaining a portfolio duration target requires the REIT to pare back the hedge. The portfolio is short the hedge, however, and paring back in a rally locks in a loss on the hedge. When rates rise, the asset side of the position generates a loss. Instead of continually rebalancing its position and taking small losses, REITs can buy interest rate options. But options over time cost roughly as much as delta-hedging. Options in practice still protect portfolios in markets where rates move too fast for a portfolio to delta-hedge. Portfolios that hedged with options probably did better over the last few weeks than portfolios that tried to delta-hedge.

mREITs often have a much harder time hedging mortgage spreads since the market offers few efficient instruments to offset the risk. mREITs trying to hedge residential risk could go short pass-through TBA contracts. mREITs trying to hedge CMBS or commercial mortgage loans could use CMBX swaps. But the cost of the short in almost all cases would cut spread income and dividends to unacceptably low levels. mREITs consequently end up with leveraged exposure to spreads.

Size of the market

The latest Financial Accounts of the United States shows mREITs at the end of 2019 held $334.7 billion in MBS and $272.9 billion in loans. With spreads wider year-to-date for almost all MBS and loans, REITs should face steady pressure to deleverage. That should keep mortgage spreads reliably soft.

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