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The Federal Reserve is anticipated to implement its first interest rate cut in what could be the beginning of a series of reductions aimed at stabilizing the U.S. economyThis shift in monetary policy is expected to significantly impact the Dividend sector, particularly mortgage REITs (real estate investment trusts) which focus on mortgage-backed securities (MBS).
Mortgage REITs and Interest Rate Dynamics
Mortgage REITs are specialized entities that invest in MBS and fund these investments using short-term financing, such as repurchase agreements (repos)They generate revenue from the difference between the interest rates on their funding sources and the yields from their MBS investmentsThis model often includes leveraging to amplify returnsTo meet tax requirements, these REITs distribute most of their investment income as dividends.
Interest rate changes have a substantial effect on mortgage REITsWhen the Federal Reserve increases rates, the market value of MBS held by these REITs tends to declineThis occurs because higher interest rates can lead to decreased values for fixed-rate securities, as new securities offer higher returns, making older ones less attractiveConversely, a reduction in rates can improve the value of MBS portfolios and potentially enhance book values.
Effects of Rate Cuts on MBS Value
Mortgage REITs faced challenges in recent years due to aggressive rate hikes by the Fed, which led to a drop in the value of their MBS holdingsAs the Fed begins to cut rates, it is anticipated that the value of these MBS portfolios will increaseThis is due to the narrowing of spreads between MBS yields and Treasury yields, which had widened during periods of rising rates.
As the yield curve begins to steepen with rate cuts, more financial institutions may re-enter the MBS market, which could further narrow the spreads and benefit mortgage REITsThis shift is expected to positively impact the value of MBS portfolios held by these REITs.
Key Mortgage REITs to Watch
AGNC Investment (NASDAQ:AGNC) and Annaly Capital Management (NYSE:NLY) are two notable mortgage REITs positioned to benefit from a declining interest rate environmentAGNC's portfolio, as of the end of the second quarter, consisted of over 98% agency MBS, with a significant portion in 30-year fixed mortgagesAnnaly also has a substantial portion of its portfolio in agency MBS, with about 88% invested in these securities.
AGNC has indicated that a 25-basis-point decrease in MBS-to-Treasury spreads could positively impact its book value by 12.6%, while a 50-basis-point decrease might boost its book value by over 25%Annaly has reported that a similar narrowing of 15 to 25 basis points could improve its book value by 6.2% to 10.4%, respectively.
In terms of valuation, AGNC trades at 1.23 times book value, while Annaly Capital Management is at 1.06 times book valueAGNC offers a yield of 13.9%, compared to Annaly's 12.7%Both REITs are expected to benefit from the Fed's rate cuts and the anticipated narrowing of MBS-to-Treasury spreads, which could result in increased book values and potentially higher dividend yields.
