Uncategorized

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.

admin
jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2023 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.

The Library

Search Articles