As REITs emerge as a key source of agency MBS demand and become the marginal buyers for mortgage-backeds, spreads are still range-bound even though there is the news that the Treasury is unwinding its MBS portfolio, according to Bank of America Merill Lynch analysts in a report released today.

In 2008, the Federal Reserve increased its balance sheet at a time when the rest of the financial industry was deleveraging. Given that financial markets have healed in the last two years and spreads have compressed, leverage is becoming key in boosting returns, analysts said.

With leverage returning to private markets, the Fed and the Treasury have been successful in reducing their portfolios of agency MBS without resulting in spread widening, BofA Merrill researchers stated

But, the ability of these investment vehicles to absorb this supply is very dependent on the rate environment, they said. 

In the longer term, REITs alone will not be able to absorb all the supply from the GSEs, the Fed, and the Treasury, analysts said. This is why other buyers including money managers, banks, and overseas investors will have to step in.

BofA Merrill analysts also noted that REIT capital raising accelerated after the Fed's QE2 announcementin October 2010. Since October 1, 2010, the yield curve has steepened by 65 basis points while equity markets are up 15%, and prepayments fears have been lessened, analysts stated in the report.

The yield curve is expected to stay steep given that the market is expecting the Fed to stay on hold, while the inflation and growth outlook are likely to pressure the back end of the curve higher, analysts noted

These market conditions are ideal for agency mortgage REITs to perform well, they said. Thus it is not surprising that mortgage REITs have been able to raise capital at a relatively quickly in the last three to four months, analsyts said.

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