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January 25, 2019  

REITs Shy Away From Risk-Transfer Bets

Mortgage REITs have largely stopped buying risk-transfer securities from Fannie Mae and Freddie Mac.

AGNC Investment, Annaly Capital, Invesco Mortgage Capital and MFA Capital are among buyers that have pulled back for the time being. Their moves come after investors booked heavy losses in November and December, when the values of the deals’ senior notes dropped to an average of 93 cents on the dollar from 97 cents in October and near par in August.

The decline was particularly painful for mortgage REITs due to their use of leverage. Take Invesco, whose portfolio of risk-transfer bonds accounts for about 5% of its overall assets. The losses Invesco booked on that portfolio alone dragged down its book value 1-2%, according to Keefe, Bruyette & Woods analysts.

Invesco funds its risk-transfer investments via one-month repurchase lines at an average financing rate of 3.3%. At yearend, its portfolio of those securities was valued at $842 million. AGNC’s risk-transfer portfolio was valued at $997 million, amounting to 1% of its total assets. Annaly was holding $689 million of risk-transfer paper, also equal to 1% of its assets. And MFA held $539 million of the notes, equal to 5% of assets.

Invesco is perhaps more vulnerable than its peers to a market selloff due to the fact that it favors higher-yielding B-class notes of Fannie and Freddie issues. In December, B1-class notes were trading around 470 bp over one-month Libor — 96 bp wider than in October.

AGNC, Annaly and MFA, meanwhile, focus more on M2 classes, which offer more credit protection and slightly lower yields. Those bonds were trading last month around 275 bp, compared to about 203 bp in October.

The market for risk-transfer securities tends to move up and down with the stock market, which explains the sharp drop in bond values in the fourth quarter. Prices have recovered somewhat since the start of the year, in line with stocks — potentially drawing the REITs back to the market.

But for the moment, prices of risk-transfer securities remain well below their levels in mid-2018. M2 paper, for example, has moved in only about 25 bp since the start of the year.

The timing of the market drop was particularly bad for the mortgage REITs because they had only recently resumed buying risk-transfer paper following a period when prices had risen too high.

“A few of these shops really got caught flat footed,” one source said.