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Agency mortgage REITs were some of the best performing investments during the first half of 2012. Their strength then was largely based on the corresponding strength of the dollar and U.S. Treasuries. More recently, though, the asset class has fallen on hard times due to mounting concerns, including decreasing spreads, rising prepayments and probable dividend cuts, not to mention the rapidly approaching fiscal cliff. These increased risks and the uncertainty that now clouds the market have caused most agency mREITs to decline substantially over the last few weeks. Although these declines may continue, these agency mREITs appear considerably more attractive investments than they have been for several quarters.

Over the last few months, most agency mREITs have weakened considerably. See the three month comparison chart, below, showing the performances for three agency mREITs, American Capital Agency (NASDAQ:AGNC), Annaly Capital Management (NYSE:NLY) and Hatteras Financial (NYSE:HTS), as well as two mREIT indexed ETFs, the FTSE NAREIT Mortgage REITs Index ETF (NYSEARCA:REM) and the Market Vectors Mortgage REIT Income ETF (NYSEARCA:MORT). Both ETFs also have exposure to non-agency residential mREITs, commercial mREITs and other hybrids. (click to enlarge)

Agency mortgage REITs hold portfolios composed exclusively of residential mortgage backed securities that are insured by federal agencies, which means they come with an agency backing and an implied U.S. government backing. Most investors allocate to mortgage REITs for the income. Generally, mREITs leverage their assets in order to multiply the return, and agency mREITs are usually the most levered mREITs due to the relatively low yield that agency debt offers.

As interest rates declined over the last several years, U.S. Treasuries and agency backed debt appreciated. In addition to the yield received from agency-backed RMBSs, agency mREITs recognized increased book values due to that RMBS appreciation. More recently, prepayment increases have cut into this appreciation, because prepayments are being made at prices below market valuation.

Prepayments are increasing because of both the continued buying of mortgage securities by the Federal Reserve and continued refinancing by qualified mortgage holders. During the third quarter of 2012, prepayments reached their highest rate since 2005. This means that the portfolios held by these agency mREITs are being cashed out at an accelerating rate, and generally at a discount to market value. This causes multiple problems for agency mREITs, which not only lose an unrealized gain due to the difference between market valuation and prepayment price, but which will also need to reinvest into a new investment at lesser yield.

As a result of all this, several agency mREITs have instituted share repurchase plans. While repurchase plans are somewhat common within the world of equities, mREITs normally refrain from such plans. In fact, most agency mREITs usually go to the market to sell additional shares through secondary offerings in order to raise funds and expand their operation. This general move is based upon the requirement that REITs pay out at least 90% of their income in dividends in order to avoid being taxed at the corporate level.

Agency mREITs such as American Capital Agency and Annaly Capital Management have announced sizable repurchase plans so far in the fourth quarter. Those plans are largely designed to give management the ability to repurchase shares when trading at a discount to book value. Such purchases are likely to be preferable to buying more agency RMBSs at prices that will be comparably higher than their own equity.

In addition to the unorthodox but seemingly sensible repurchase maneuvering by Annaly and American Capital Agency, Annaly also recently announced its intention to acquire Crexus (NYSE:CXS), a commercial mREIT that is partially owned by Annaly and managed by FIDAC, a wholly-owned subsidiary of Annaly. While it is unclear what Annaly would end up doing with CXS' holdings if the acquisition happens, it would appear to convert Annaly from an agency-only mREIT to a hybrid.

Other agency mREITs may be wary of following Annaly down this road, as it may make some investors wary of the investment and it also exposes the portfolio to a new asset class that will have a new set of risks associated with it. Annaly's decision was motivated by a search for yield and a sense of caution over increasing leverage rates, but some competing agency mREITs may instead opt for increased leverage or some alternative option in the search for yield.

In addition to taking unorthodox steps, agency mREITs appear poised to reduce their dividends in the near future. These companies pay out their dividends by leveraging the difference between their borrowing costs and the yield their investment portfolio pays out, and narrowing spreads have made it increasingly difficult for agency mREITs to maintain their dividends. Declining spreads and leverage rates indicate that dividend cuts are looming, some of which may be announced before the end of 2012.

Though somewhat anticipated, any future dividend cuts will likely result in further agency mREIT equity declines. Nonetheless, the asset class appears better valued than it has been for several months, if not longer, and it is likely that most mREITs will decline- more in anticipation of such dividend cuts than they will when those probable cuts are actually announced. As a result, it currently looks like a sensible time to start scaling into agency mREITs, with the intention of adding on further weakness, and with the understanding that dividend cuts are likely.

Additionally, agency mREITs dividends are taxed as regular income and not at the lower corporate dividend rate. This means that the asset class should not be negatively affected by the scheduled increase to the corporate dividend rate, but that it would be affected by an increase to the income tax rate, unless held within a tax deferred or exempt account.

Source: It Is Time To Start Accumulating Agency Mortgage REITs