Profiting From A Steepening Yield Curve
What is the
yield curve and what does it mean for the economy and the markets?
last few months, the financial media has obsessed on those questions. Given the
yield curve’s importance, especially considering the large amount of debt being
carried by individuals, corporations, and the government, we do not blame them.
In fact, we have given our two cents quite a few times on what a flattening and
inversion of various yield curves may be signaling. Taking our analysis a step
further, we now look at investment ideas designed to take advantage of expected
changes in the yield curve.
of the 2yr/10yr Treasury yield curve, where yields on 10-year Treasury notes
are lower than those of 2-year Notes, has accurately predicted the last five
recessions. This makes yield curve signaling significant, especially now. It is
important to note that in the five prior instances of yield curve inversions,
the recession actually started when, or shortly after, the yield curve started
to steepen to a more normal positive slope following the inversion. In our
opinion, the steepening, and not the flattening or inversion of the curve, is
the recession indicator.
Perfect Recession Warning May Be Failing You, we believe the
2yr/10yr curve may not invert before the next recession. It may have already
troughed at a mere 0.11 basis points on December 19, 2018. If we are correct,
the only recession warning investors will get could be the aforementioned curve
steepening. Another widely followed curve spread, the yield difference between
3-month Treasury bills and 10-year Treasury notes, recently inverted and troughed
at -25 basis points, which makes the likelihood of a near-term recession
remainder of this article focuses on REITs (real-estate investment trusts).
Within this sector lies an opportunity that should benefit if the yield curve
steepens, which we noted has occurred after an initial curve inversion and just
before the onset of the last five recessions.
What is an Agency Mortgage REIT?
companies that own income-producing real
estate and/or the debt backing real
estate. REITs tend to pay higher than normal dividends as they are legally
required to pay out at least 90% of their taxable profits to shareholders
annually. Therefore, ownership of REIT common equity
requires that investors analyze the underlying assets and liabilities of the
REIT to assess the potential flow of income, and thus dividends, in the
popular types of REITs are called equity REITs. These REITs own equity in apartments
and office buildings, shopping centers, hotels and a host of other property
types. There is a smaller class of REITs, known as mortgage REITs (mREITs),
which own the debt (mortgages) on real-estate properties. Within this sector is
a subset known as Agency mREITs (AmREITs) that predominately own securitized
residential mortgages guaranteed against
default by Fannie Mae, Freddie Mac, Ginnie Mae and ultimately the U.S.
investor’s point of view, a key distinguishing characteristic between equity REITs and mREITs is their risk
profiles. The shareholders of equity REITs
are chiefly concerned with vacancy rates, rental rates, and property values. Most mREIT
shareholders, on the other hand, worry about credit risk and interest
rate risk. Interest risk is the yield spread between borrowing rates and the
return on assets. AmREITS that solely own agency guaranteed mortgages assume no
credit risk as timely payment of principal and interest is advanced by the
security issuer (again either Fannie Mae, Freddie Mac, or Ginnie Mae, all of
whom are essentially government guaranteed). Therefore, returns on AmREITs are heavily
influenced by interest rate risk. Almost all REITs employ leverage, which
enhances returns but adds another layer of risk.
AmREITs are primarily the product of two sources; the amount of net income
(yield on mortgages they hold less the cost of debt and hedging) and the amount
AmREIT is funded with equity financing and debt. The capital is used to purchase
government-guaranteed mortgages. Debt funding allows them to leverage equity. For
example, if a REIT bought $5 of assets with $1 of equity capital and $4 of
debt, they would be considered 5x leveraged (5/1). Leverage is one way REITs
The second common
way they enhance returns is to run a duration gap. A duration gap means the
REIT is borrowing in shorter maturities and investing in long maturities. A 2-year
duration gap implies the REIT has an average duration of their liabilities that
is two years less than the duration of their assets. To better manage the
duration gap and the associated risks, REIT portfolio managers hedge their
The Fed’s Next Move and AmREITs
bit of knowledge, now consider the Fed’s quickly changing policy stance, how
the yield curve might perform going forward, and the potential impact on REITs.
speeches from various Fed members including Chairman Powell and Vice Chairman
Clarida are leading us and most market participants to believe the Fed could
lower rates as early as the July 31st FOMC meeting. Most often,
yield curves steepen when, or shortly before, the Fed starts lowering rates. While
still too early to declare that the yield curve has troughed, it has risen meaningfully
from recent lows and is now the steepest it has been since November of
If we are
correct that the Fed reduces the Fed Funds rate and the yield curve steepens,
then AmREITs should benefit as their borrowing costs fall more than the yields
of their assets. Further, if convinced of a steepening event, portfolio managers
might reduce their hedging activity to further boost income. The book value of
AmREITs have a strong positive correlation with the yield curve, and as a
result, the book value per share of AmREITs should increase as the curve
following two graphs compare the shape of the 2yr/10yr yield curve versus the
book value per share for the two largest AmREITs, Annaly Capital Management
(NLY) and AGNC Investment Corporation (AGNC). The third and fourth graphs below
show the same data in scatter plots to appreciate the correlation better. The
current level of book value per share and yield curve is represented by the
orange blocks in each scatter plot. Statistically speaking, a one percent
steepening of the yield curve should increase the book value per share by
approximately $2 for both stocks. Given
both stocks have dividend yields in the low double-digits, any book value
appreciation that results in price appreciation would make a good return, great.
Data Courtesy Bloomberg
steepening yield curve will likely create more spread income and thus a higher
book value for these REITs, we must also consider the role of leverage and the
premium or discount to book value that investors are currently paying.
is employing 8.2x leverage, which is slightly higher than their average of 7.6x
since 2010, but less than their 20+ year average of 9.94.
uses more leverage at 10.2x, which is higher than their average of 8.8x since
2010. The REIT was formed in late 2008, therefore we do not have as much data
trades at a discounted price to book value of .94, slightly below their
also trades at a discounted level of .92 and below their historical average.
The risks of
buying AGNC or NLY are numerous.
may be wrong about the timing of rate cuts and the curve may continue to
invert, which would decrease book value. In such a case, we may see the book
value decline, and potentially even more damaging, the discount to book value decreases
further, harming shareholders.
if we are right and the yield curve steepens and the REITs asset/liability
spreads widen, we run the risk that investors are nervous about real-estate
going into recession and REITs trade to deeper discounts to book value and
effectively offset any price appreciation due to the increase in book value.
is easy to maintain when markets are liquid; however, as we saw a decade ago,
REITs were forced to sell assets and reduce leverage which can also negatively
affect earnings and dividends. It is worth noting that NLY had an average of
12.90x leverage in 2007, which is significantly larger than their current 8.20x.
double-digit dividend yields and the cushion such high dividends provide, buying
NLY or AGNC is not a guaranteed home run. The two REITs introduce numerous risks
as mentioned. That said, these firms and
other smaller AmREITs, offer investors a way to take advantage of a steepening
yield curve while avoiding an earnings slowdown that may hamper many stocks in
an economic downturn.
and AGNC are in the same industry, they use different portfolio tactics to
express their views. As such, if you are interested in the sector, we recommend
diversifying among these two companies and others to help reduce idiosyncratic
portfolio risks. We also recommend investors assess the IShares Mortgage Real
ETF (REM). Its two largest holdings, accounting for over 25% of the ETF, are
NLY and AGNC. It is worth noting however,
this ETF introduces risks not found in the AmREITs. The ETF holds the shares of
mortgage REITs that contain non-guaranteed mortgages as well as mortgages on