Latest / Bull Market Conversations with Fexingo: Rallies, Momentum, and Riding Market Strength / How the Fed Funds Rate and S&P 500 Bull Market Are Changing Mortgage REITs
Transcript
- Lucas: So the S&P 500 is sitting at 7,572, the NASDAQ is above 26,000, and yet there is a corner of the market that has been completely left behind by this bull run — mortgage REITs. Luna: Mortgage REITs? I feel like we haven't talked about them in a while. What's happening? Lucas: They are the classic carry trade — borrow short-term at the Fed funds rate, which is 3.63 percent, and invest in longer-term agency mortgage-backed securities that yield maybe 5.5 to 6 percent. In a normal yield curve, that spread is easy money. But we've had an inverted yield curve for over two years now. Luna: Right, short-term rates are higher than long-term rates. So the spread is negative or close to zero. Lucas: Exactly. The big mortgage REITs — Annaly Capital Management, AGNC Investment, Starwood Property Trust — they have had to get creative. They hedge using interest rate swaps and Treasury futures to protect book value, but that costs money. Their net interest margins have been compressed to almost nothing. Luna: But they still pay dividends, right? I think Annaly yields something like 12 percent. Lucas: 12.5 percent as of last week. But the question is whether that dividend is sustainable. They are paying it out of cash flow, but a lot of that cash flow comes from rolling hedges and realizing gains on mortgage servicing rights — not pure net interest income. Luna: So it's not the same as a utility stock dividend. Lucas: No, it's much more volatile. And because the Fed funds rate has been flat at 3.63 since June, the market is pricing in rate cuts maybe next year. If the curve normalizes, mortgage REITs could rally significantly. But if rates stay higher for longer, they keep bleeding. Luna: There was that headline yesterday — Warren Buffett saying 'it's tough to find values when everybody is preferring gambling.' Do you think mortgage REITs are the kind of value he means? Lucas: I think he means something different — he's talking about the overall market being expensive. But yeah, mortgage REITs are trading at deep discounts to book value. Annaly's book value per share is around $23, and the stock is at $19. So there's a 17 percent discount. The market is pricing in more pain. Luna: And they've been reducing leverage to survive. I saw that Annaly's debt to equity ratio dropped from 7.5 to 6.2 over the past year. Lucas: That's a big de-levering. In a bull market where everyone is piling into risk, these guys are pulling back. It's almost contrarian. But if the yield curve un-inverts, they could see a double boost — higher net interest income and a re-rating of book value. Luna: So what's the catalyst? Is it the Fed cutting rates? Or something else? Lucas: The Fed cutting short-term rates would help, but what would really help is the long end of the curve staying where it is while short rates fall — that steepens the curve. The market is pricing in a cut in late 2026 or early 2027. If that happens, mortgage REITs could be one of the best plays. Luna: But it's a bet on the timing of monetary policy. That's never easy. Lucas: No, and there's also the risk that the housing market slows further, which could increase prepayment speeds or defaults on the underlying mortgages. Agency MBS are guaranteed by Fannie and Freddie, so credit risk is low, but prepayment risk is real. Luna: And if rates stay high, homeowners don't refinance, so prepayments slow — actually that helps mortgage REITs, right? Their assets stay on the books longer. Lucas: Exactly. In a way, the current environment is bad for net interest income but good for asset duration. It's a trade-off. The market hates uncertainty, and mortgage REITs are pure uncertainty plays right now. Luna: So for the average listener who's looking at their portfolio, is this something to consider? Or too niche? Lucas: I think it's a small tactical allocation for people who have a view on the yield curve. If you think the curve steepens in the next 12 months, mortgage REITs could return 20 to 30 percent including dividends. But if the curve stays inverted, you could lose 10 to 15 percent more. Luna: That's a wide range. Not for the faint of heart. Lucas: No. And that's why they're not part of the bull market narrative. The S&P 500 is up 12 percent this year, but the mortgage REIT index is down 5 percent. It's a reminder that 'the market' is not one thing. Luna: And that's what makes these conversations valuable — understanding the parts that are being left behind. Lucas: If our money conversations have helped you think about a decision differently — whether it's about REITs or the broader market — one way to keep this show ad-free and independent is to support us at buy me a coffee dot com slash fexingo. Luna: Yeah, it really does make a difference. Every contribution helps us keep digging into these overlooked corners of the market. Lucas: So let's get back to the yield curve. One thing I find interesting is that the mortgage REITs have actually been buying more agency MBS recently — they see the discount as an opportunity. Luna: So they're doubling down despite the pain. Lucas: Exactly. Annaly's CEO said on their last earnings call that they are positioning for a normalization of the curve. They've been extending duration on their hedges. It's a bold move — they're essentially making a leveraged bet that the Fed will cut rates within the next year. Luna: And if they're right, shareholders could be rewarded handsomely. But if they're wrong, book value takes another hit. Lucas: Right. And that's the thing about bull markets — they create an appetite for risk. But mortgage REITs are a reminder that risk can go both ways, even when the overall market is up. Luna: Lucas, what's the one thing you want listeners to take away from this episode? Lucas: That the yield curve matters for a lot more than just bond traders. It determines the profitability of a trillion-dollar industry that finances a huge chunk of American home loans. And right now that industry is in a fight for survival. Luna: And that's a story worth watching. Lucas: Absolutely. We'll keep an eye on it.