Real estate investment trusts with heavy investments in Fannie Mae and Freddie Mac bonds are currently feeling the squeeze from the recent spike in 10-year Treasury rates, along with other adverse market conditions.
Now two analysts at Deutsche Bank (DB) are warning that REITs selling off these mortgage bonds to meet leverage ratios is likely to continue, applying more pressure to bond pricing.
In their latest The REIT Stuff report, Deutsche analysts Ian Carow and Christopher Helwig, estimate REITS sold $29 billion (out of an approximate total $270 billion in assets by market value) since the end of the first quarter.
"And further steepening in the yield curve and widening of mortgage spreads could lead these same REITs to sell an additional $12 billion to $24 billion, flows that would put significant further pressure on MBS pricing," they write.
As banks and REITs continue to sell off these agency bonds, liquidity levels in the market become constrained. Locks on liquidity can enhance into secondary market slowdowns as a worse case — as seen in the run-up to the credit crisis. However, Deutsche Bank says this is unlikely to occur as declining liquidity in agency MBS has contrasted with improving liquidity in the private mortgage bond market. A net 20% of respondents reported better non-agency MBS liquidity in the first quarter a steady improvement since early 2012.
Indeed, daily trades in agency MBS hover around $316 billion, the second-largest secondary market after Treasurys. The private label market, by contrast, trades around $1.5 billion every day.
The analysts' scenario assumes a market where rates continue to rise and spreads continue to widen. This form of delta hedging, accounting for price movements in the underlying asset, will also likely be concentrated in 30-year pass throughs.
"It is clear from Helwig and Carow’s analysis that REITs have likely spun off material flows in MBS and contributed to some of the widening and basis volatility in MBS," explains colleague Steven Abrahams in his related analyst of The REIT Stuff report.
"Aggregate REIT deleveraging in the second quarter looks like it is equivalent to nearly 16% of the estimated delta hedging from mortgage servicers, making REITs a force worth monitoring," Abrahams said.