Attractive Returns to Continue, Prefer Non-Agency REITs
Prefer non-Agency: Heading into 2012 we think that the hybrid/non-Agency REITs generally offer more attractive value with the potential for more capital appreciation plus a more stable dividend outlook given the attractive reinvestment environment.
TWO remains top pick: Against this framework Two Harbors remains our top pick among the mortgage REITs. The company has been opportunistically adding to its non-Agency position at incrementally accretive risk-adjusted yields. This combined with the Agency portfolio with favorable prepayment characteristics gives us confidence in the sustainability of the current 16.8% yield.
Agency MBS: While the net interest spread opportunity in the Agency MBS space contracted during 2011 the returns remain attractive by historical standards. In addition the reduced uncertainty around the prepay environment, specifically government actions, should make for a more predictable return path than in 2011.
Non-Agency MBS: In 2012 we continue to see the spread environment remaining attractive on a risk-adjusted basis with incremental spreads higher than the existing realized spreads. It is more challenging to know how the securities will perform on a mark to market basis, which will be dependent on the broader
market risk appetite over the short-term.
Capital Raising: Given the attractive level of returns we see that the mortgage REITs will continue to have an appetite to raise additional capital. The current gating factor is stock prices; current valuations would generally not allow the mortgage REITs to raise new stock at a price below book value. We see the need for 6-7% premium in the group for offerings to become more likely.
Valuation: The relationship between price to book and ROE is less correlated today than it has been in the past as investors are putting a greater premium on safety versus returns. This results in higher price to book multiples for the Agency REITs versus the broader group of hybrids.
The table below displays the mortgage REITs with the highest equity score (compellation of analyst opinions with 10 being Very Bullish).