Volatile rate movements are sparking fears that real estate investment trusts may be forced to sell agency mortgage-backed securities, analysts claim.
Some investors now argue that agency REITs – which have a portfolio size rivaling Fannie Mae and Freddie Mac – could be forced to sell as rates shift, analysts for JPMorgan Chase claim.
"We believe that while REITs are somewhat sensitive to rates, the bigger issue for them is spreads, and that the current environment is really one of 'spread convexity' hedging, not traditional rate convexity hedging, as witnessed in 2003," the JPMorgan (JPM) analysts explained.
A bigger issue for REITs is mortgage underperformance, whether through spread widening, convexity sliding or unhedged volume increases, JPMorgan added.
For instance, mortgages have underperformed their hedges by about a point during the past few weeks. In that scenario, assets go from par to 99, but liabilities remain unchanged since it’s purely an underperformance of the asset.
To recap what’s happened since early April, the price of Fannie Mae coupon 3.5s dropped by a little more than two points – worth around $4 billion of MBS selling for the industry – while mortgages underperformed by roughly a point – worth nearly $35 billion of selling, the report noted.
Thus, any pressure that’s come to REITs has been from the underperformance of the sector primarily, not so much from the rate move itself.
"Consequently, REITs are a much bigger source of 'spread convexity' hedging than they are of traditional rate convexity hedging," the analysts said.
However, note that rate moves and underperformance are correlated. Therefore, underperformance can come from traditional spread widening or it can come from convexity.
While mortgage rates have underperformed, they haven’t cheapened as much as investors may think.
For REITs, both spread widening or large rate moves trigger underperformance, and thus both can lead to possible selling.
"We reiterate that these numbers are probably upper bounds for REIT selling, however, since REITs may choose to issue equity or simply allow their leverage ratio to drift higher," according to JPMorgan analysts.
As a final point, one main area of concern for REITs is the availability of their funding.
While average terms of repossessions have extended during the past year, the industry still relies heavily on repo availability. Consequently, agency REITs have only witnessed modest increases in haircuts during and after the crisis, whereas private-label REITs have posted much higher increases.
"We are not overly concerned about the availability of repo funding to the industry locally," the analysts stated.
They concluded, "A massive sell-off that puts significant pressure on a REIT’s equity could cause lenders to re-evaluate, but that would probably require a far greater sell-off or spread widening scenario than we have seen in recent months."