Real Estate stocks historically do well in a declining interest rate environment because they pay their dividends and hold hard assets. But Mortgage REITs can be a different story.
The usual route to running a Mortgage REIT is to borrow money at cheap short-term rates and buy longer-term debt that pays enough interest to cover the short-term loans, keep the cycle going and distribute significant cash to shareholders. It's a great system when the spread between short- and long-term rates is normal.
As that spread narrows, the room for profit shrinks with it. So does the margin of error. We've already seen a few of our Mortgage REIT recommendations cut their dividend because they don't want to take on additional leverage to squeeze profit in this environment, but playing the spread as it is just doesn't generate as much cash as it once did.
Now there's a lot of talk about the spread turning negative as long-term rates dip below the near end of the yield curve. It now costs 2.09% to borrow money for a month while bonds maturing 10 years from now pay only 1.65%. An experienced debt manager can always find places to park money and do a little better, but it's hard to swim that hard upstream all the time.
And now that $15 trillion in bonds around the world are trading at negative interest rates, it gets even harder. German, Japan and other European nations now have bonds that are trading at up to -0.6% interest rates. That means that if you buy a $100,000 10-year German bund, you will receive well less than $100,000 10 years from now when it matures.
Here's the interest rate on that negative-rate German debt over the past year:
And a look back at the last five years shows that this isn't an isolated glitch. German rates have been flirting with zero and below for a long time now:
The big question is whether something similar can happen here in the U.S., especially now that the Fed has joined other central banks in relaxing monetary policy. No one knows for sure, but there's a good possibility that it could happen here. The Fed doesn't control long rates, but if they keep lowering short rates towards zero and then have to institute a bond buy-back campaign, long notes and bonds might just start approaching zero. That means it's going to get even harder for Mortgage REITs to make money on the long end.
And what if inflation continues to deteriorate and deflation sets in with a vengeance? Then we might just see negative rates. And what if it all leads to a recession, which these kinds of things predict with pretty good accuracy? We would see negative rates and a lot of pain for companies that would need to accept negative returns and still satisfy their shareholder obligations. You can't pay dividends with negative cash flow.
This leads us to three stocks we have in our portfolios that could be troublesome: Annaly (NLY: $9.32), New Residential (NRZ: $14.46) and AGNC Investment (AGNC: $16.85). We love these stocks. You've heard us talk about the first two for years. Annaly and AGNC in particular make money on the spread. The spread is so narrow now that Annaly has already cut its dividend from $0.30 to $0.25 per quarter to provide a little relief.
New Residential, on the other hand, invests in instruments that make money when rates go up, but guess what? Rates have been moving the other way lately.
Again, we love all three of these stocks. They've been reliable dividend payers for years and Annaly and AGNC have made BMR subscribers good money in their time with us. But the last time the yield curve looked like this, Mortgage REITs cratered 75% in the following two-year period. That's not the kind of decline that quarterly dividends repair fast, even assuming those dividends keep coming.
Of course the curve can recover, in which case these stocks will rebound as well. Otherwise, we don't see a lot of upside in hanging on for the long term. If these stocks keep falling, we'll get out and come back when it's clear that the knife has stopped falling. In that scenario, BMR subscribers will undoubtedly lock in much better yields than you're seeing now, with the added bonus of avoiding a major risk period.
If Annaly hits $9.05, we're out. If New Resi hits $14.30, we're out. (It was down 53 cents today to $14.46.) If AGNC hits $16.65, we're out. Watch your positions closely.