Mortgage REITs make money by investing in mortgages, plain and simple. They amplify their IRR by borrowing money to invest in mortgages. When the FED is holding rates low, these mortgage REITs have a huge advantage which is why many of them are paying dividend yields upwards of 15%. So for now, the carry trade lives on.
One of our favorite picks in this space is Two Harbors (TWO) which is currently yielding 15%. TWO is a hybrid real estate investment trust (REIT) which means it invests in both Agency and non-Agency residential mortgage-backed securities (RMBS). Agency mortgages are guaranteed by the government so they carry virtually no credit risk and as a result lower yields. Non-agency mortgages, however, do not have their credit guaranteed by government agencies and thus offer higher yields. For a fundamental credit shop, this space offers an excellent value-add opportunity to add “alpha” through better research.
TWO offers some insights into its non-agency portfolio in its latest 10Q. The average coupon on their loans is a little over 9% with an average FICO score of 640 and a delinquency rate of about 40%. So, they’re paying a higher coupon rate for good reason…
Their website offers a good factsheet that outlines their portfolio yield:
…So with near term interest rates near zero, and a total blended yield of 4.9%, TWO can borrow money cheaply, invest it at close to 5% and thus push their cash-on-cash return (return on equity) up to the double digits – thus being able to pay the equity holders 15% yields.