What a Kevin Warsh-Led Fed Could Mean for Mortgage REITs AGNC and Annaly Capital

Kevin Warsh was recently installed as the head of the Federal Reserve. Although he was a loud proponent of cutting rates not too long ago, economic conditions have changed. The first Federal Reserve meeting of his tenure ended with no change to rates, with the target range remaining at 3.5% to 3.75%.

That alone is an important piece of information for mortgage real estate investment trusts (REITs) like Annaly Capital (NYSE: NLY) and AGNC Investment (NASDAQ: AGNC). But it isn't the only takeaway from the meeting you need to know about if you own these high-yield stocks, or are considering buying them.

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Starting with rates, the direction has changed

Warsh had long been a proponent of lower rates, a view that paired up with the president who nominated him to the position he now holds. That rates were held steady and not cut is an important statement about the Fed's independence. However, it also indicated that the economic situation in the United States had changed, with inflation worries rising materially. At this point, it looks more likely that rates will rise than fall.

That's not great news for Annaly and AGNC. These two mortgage REITs own bond-like securities created by pooling mortgages. As with most bonds, rising interest rates cause the value of existing bonds to decline. That has to happen to keep the yield of the existing bonds competitive with the rates being offered by newly issued bonds. In the near term, a rising rate environment will likely lead to a reduction in tangible net book value per share for both Annaly and AGNC.

There's a silver lining on the rate cloud

While a declining tangible net book value per share in the face of rising yields is bad news, the new mortgage security investments that AGNC and Annaly make will have higher yields. That's a positive that could benefit further from other changes that Warsh has been discussing. Most notably, the Fed chief would like to see the Fed shrink its balance sheet, which he believes would increase the Fed's independence as it would no longer be backstopping the government. That would lead it to sell mortgage securities, among other assets.

Without the Fed in the mortgage securities market, effectively soaking up supply, spreads would likely widen. This, too, would likely put pressure on tangible net book value per share in the near term. However, it would mean that future purchases would be more profitable. So, like the rate change, a near-term negative, but a potential long-term positive.

That said, Warsh hasn't made any changes here either. The new Fed chair has created a series of committees to examine the way the Fed currently operates. The Fed is committed to providing the banking system with ample liquidity, but the role it has been playing since the Great Recession appears likely to change. AGNC and Annaly will be watching the changes very closely, as should shareholders in these high-yield REITs.

Well-respected, but risky high-yield stocks

AGNC and Annaly have dividend yields above 13%. That's 13x the yield currently available from the S&P 500 index (SNPINDEX: ^GSPC). While the yields are attractive on an absolute basis, both mREITs have volatile dividend histories, with periods when dividends were cut. Given the near-term headwinds that could be on the horizon, yield seekers should probably tread with caution.

However, AGNC and Annaly are both designed to pay large dividends and are well-respected mREITs. If you can stomach a volatile income stream, the Fed under Warsh could actually lead to higher dividends over the longer term, as new investments these mREITs make have higher yields and wider spreads. But there will be significant uncertainty in the near term before an improved investment environment is likely to emerge.

Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.