If Chasing Yield Is All You Are After, Mortgage REITs May Not Be Your Best Bet

Includes: AGNC, CIM, CXS, CYS, NLY
by: Matt Schilling

On September 13, the Federal Reserve initiated its third round of quantitative easing, better known as QE3, and in doing so changed the entire landscape of the Mortgage REIT sector for what many investors would hope to be only a short while. As part of the Fed's efforts to get the economy back on track, it has established a program to buy $40 billion of mortgage-backed securities and $45 billion in treasuries each month.

This program itself was designed to serve two purposes, an easing of various mortgage lending requirements for homeowners and to support a rebound in the housing market. As a result of the $40 billion per month spending spree many of the Mortgage REITs are taking a defensive stance by making some very desperate moves. In this article I wanted to examine some of the recent developments in the sector and one particular transaction involving one of the most-well known Mortgage REITs, Annaly Capital (NYSE:NLY).

From a fundamental standpoint, any company that currently carries $1.94 in revenue per share and $5.62 in cash per share would be considered a pretty good investment and tend to yield pretty substantially. In the case of Annaly Capital, which currently yields 14.20% ($2.00), investors need to thoroughly read between the numbers since the stock is down 18.82% since September 13, and take a good look at the company's reasoning behind its current bid for Crexus Investment (NYSE:CXS).

A Desperate Move to Diversify

On Monday November 12, Annaly Capital announced its plans for a reported "$839 million bid to acquire the 87.60% of Crexus Investment shares that it doesn't already own. Annaly Capital is bidding $12.50/share in cash, which would represent a 12.60% premium to the $11.10/share that Crexus shares had closed at on Friday". In my opinion the company's move to diversify out of Agency-based RMBS indicates the Fed may actually stay in the marketplace a bit longer than analysts had originally estimated.

As most investors know Crexus deals largely in commercial-grade paper and given the fact Fed Chairman Ben Bernanke wasn't too keen on the labor markets progress since the start of QE3, this may in fact be a small victory for shareholders of NLY. The downside however could essentially affect the yield of NLY, which currently stands at $14.20% ($2.00). As treasuries continue to trade at or near all-time lows an exuberant amount of pressure is placed on the yield curve, and as the pressure slowly mounts, the yield of not only Annaly Capital but fellow RMBS names such as American Capital Agency (NASDAQ:AGNC) and CYS Investments (NYSE:CYS) could suffer quite substantially.

The Most Important Concern of the Sector

One of the most important sector-based concerns deals with the concept of prepayments. When the number of prepayments increases it causes somewhat of a domino effect since spreads, profits, and revenue all begin to shrink significantly. Given the fact prepayments have been demonstrating a sharp increase during the third quarter; many investors are calling for the possibility of a sharp decline in spreads, profits and the precious high-yields many of these securities currently possess. Investors should note that since 2011, Annaly Capital, American Capital, Chimera Investment (NYSE:CIM) and CYS have all reduced their respected dividends multiple times.

According to Zvi Bar who recently wrote an article on the Mortgage REIT sector, "mortgage prepayment rates have hit their highest levels since before the subprime crash during the third-quarter, which was clearly fueled by homeowners continuing to refinance with borrowing costs hovering around historic lows." If all-time highs continue to be shattered and a continuous pattern is formed, the longevity and attractiveness of this sector could be short lived.

Final Analysis

Potential investors looking to establish a position in the REIT sector should consider a company's fundamentals as well as a company's yield and dividend behavior before deciding where and how to establish a long-term position. I think if Crexus was 3-4 times its current market value the deal could be justified as a positive variable moving forward. I'd personally continue to avoid a position in the sector until the Fed stops buying up $40 billion/month in mortgage backed securities, because at some point many of the remaining Mortgage REITs could run out of cash trying to keep up. The Fed's size and strength should be enough to deter investors at this point, and if it's not investors should begin to examine some of recent dividend behavior over the last two years in many of the stocks within the sector.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.