This brings me back to mortgage REITs (real estate investment trusts), a topic I last wrote about in July 2013. The largest of this group -- Annaly Capital Management (NYSE:NLY), American Capital Agency Corp. (NASDAQ:AGNC), NorthStar Realty Finance (NYSE:NRF), Starwood Property (NYSE:STWD), Chimera Investment (NYSE:CIM), and Two Harbors Investment (NYSE:TWO) -- were among the intended beneficiaries of QE1 and QE3. I noted at the time that this group was facing the strong headwind of its bond yield curve steepening relative to the Treasury yield curve. Worse, years of artificially low mortgage rates and other housing subsidies were lowering the affordability of homes for buyers, something that we've seen confirmed in recent data on home sales and construction.
It's the Yield Gap, Stupid
Mortgage REITs started to outperform all REITs after last September's postponed tapering of QE, even though they've underperformed all REITs since QE1 began in March 2009. (Will I remember all of these QE-related dates in my dotage instead of important stuff, like where I left the house keys? Just wondering). Moreover, they've done it in the aforementioned poor environment for housing and with the yield curve for mortgage bonds still steepening relative to the Treasury yield curve.
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How can this counterintuitive gain in relative performance be explained? As in the case of so many things in our yield-starved age, you have to look at relative yield gaps. Let's rearrange the data in the chart above to a relative performance measure and map it against the yield gap between mortgage REIT bonds and the dividend yield on the S&P Comp1500 (INDEXNYSEGIS:SPSUPX) supercomposite. That yield gap started to expand about one year ago, and as it did, the performance of mortgage REITs relative to all REITs stabilized and turned higher.
Click to enlarge
The sensitivity of this relative performance index to the yield gap of mortgage REIT bonds to equity dividends indicates the group is being valued more in comparison to equities than to Treasuries. As there's a long history of yield-chasing ending badly, I will have to nod in this direction and simply note that this trade will end badly if and when long-term rates rise. However, this is unlikely to be a short-term concern.
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