Agency mortgage real estate investment trusts earned promising yields and carry while taking on prepayment risk in 2012. However, Bank of America Merrill Lynch (BAC) analysts claim this strategy has reached the end of its rope.

In 2013, elevated prepayments are expected and as result, portfolio composition is projected to shift toward an even broader demand for adding prepayment protection. 

Agency REIT holdings were originally forecasted to grow by $30 billion in 2012. Through the third quarter of this year, agency REIT portfolios grew $67 billion, as equity capital raises totaled $8.25 billion. 

The key determinant of REIT equity prices will be how equity investor expectations for dividend yields adjust.

“Future equity raises are likely to be minimal, with potential for some preferred share issuance,” the report stated.

Share buybacks may also remain an appealing option with compelling yields of 10% to 15%, relative to the 8% to 12& real estate owned offered on mortgage backed securitizations.

Portfolio sales are expected to be less likely, unless the rate outlooks shifts and becomes “decidedly bearish.”

“With management incentives tied to equity, REITs are positioned opportunistically to await better entry points that may arise given the backdrop for a wide range in spreads,” the report said.

Click the graph to view mortgage REIT assets and equity raies as of 3Q12.

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