Desperately Seeking Yield Through Equities Redux: Part 2: Agency Mortgage REITs

by: Philip Mause

Probably the most widely publicized avenue for enhancing portfolio yield in equity markets has been the agency mortgage real estate investment trust (AMREIT) sector. I wrote about the sector in this article in June 2011. REITs are a bit like BDCs; they are subject to special tax provisions which permit exemption from tax at the corporate level but require the payment of 90% of income as dividends. Dividends are generally, but not always, taxed as ordinary income to shareholders: in some cases, dividends can receive other tax treatment depending upon the "source" (capital gains or return of capital) of the funds paid out.

Within the world of REITs, some REITs actually own properties and rent them out while others own mortgages and collect interest on their holdings. Mortgage REITs are generally divided into the agency and non-agency sub-sectors. AMREITs invest in mortgages or mortgage based securities backed by a federal agency such as Fannie Mae (OTCQB:FNMA) or Freddie Mac (OTCQB:FMCC) and, as a result, they are insulated from the possibility of losses due to defaults on the mortgages they own.

AMREITs have generally been attractive to investors for several reasons. The absence of default risk was a very attractive feature in the midst of the Panic of 2008-09 and the AMREIT sector performed relatively well through the crisis (I stress the word, "relatively" here - there were declines in the prices of the stocks but they were relatively small for the financial sector). AMREITS have also traditionally paid double digit dividends and the combination of high yield and no default risk was very, very attractive in 2009 and 2010. Since the Crash, this sector has seen a fairly steady flow of new offerings which, in turn, allow the companies to expand their portfolios.

Things that appear too good to be true are always, in fact, too good to be true and there are downsides to AMREITs. Because the securities they hold pay low interest rates, they can attain high dividends only by using considerable leverage. Leverage generally runs at least at the level of five units debt per one unit equity and in some cases runs considerably higher. This is tolerable because of the absence of default risk but there are other portfolio risks to be aware of and these tend to be amplified by leverage.

When I first started writing about the sector in 2010 and 2011, the risk that was on everyone's mind was "interest rate risk" - this is the risk that interest rates will increase and the mortgages held by AMREITs will decline in value. In addition, higher interest rates would mean that AMREITs would have to pay higher rates on their borrowings (which are generally floating rate or short term) and therefore earn less on the "spread" between mortgage rates and the interest costs on their borrowings. Many AMREITs hedged against higher rates and there was a general concern that higher rates were the big risk for the sector.

In fact, rates stayed low but another problem emerged. Residential mortgages in the United States are unlike most other debt instruments in that interest rate risk is a "one way street." If rates go up, the borrower can sit on his mortgage and enjoy the below market rate for up to 30 years. If rates go down, the borrower can refinance without penalty and take advantage of the lower rates. Most other debt instruments do not work this way. Corporate bonds can be repaid only pursuant to "call" provisions which often involve penalties. Commercial mortgages often work this way as well. The government does not really have any call privileges on Treasury bonds and the federal government is still paying very high interest rates on some 30 year bonds issued in the 1980s.

At any rate, a new risk emerged - "prepayment risk" - and has adversely affected the sector. In essence, borrowers with mortgages carrying rates above the market level refinance at lower rates and repay the old mortgage. The AMREIT gets a wad of cash but has to put it back into the mortgage market at a lower interest rate. The anticipation of prepayments can lead mortgage backed securities to decline in fair market value and this can result in portfolio write downs and losses. There are various strategies to minimize prepayment risk by targeting certain types of mortgages with lower prepayment risk but everyone is trying to do the same thing and so the price of those mortgages adjusts to reflect the enhanced value associated with lower prepayment risk.

When I first discussed this sector, I suggested that investors buy a diverse group of the stocks because of the risk that any single AMREIT manager would "zig" when he should have "zagged" and the results below suggest that my advice had some merit. I am providing the price on June 15, 2011, when my first article came out, Monday's closing price and the current yield for Armour Residential (NYSE:ARR), CYS Investments (NYSE:CYS), Annaly Capital (NYSE:NLY), American Capital Agency (NASDAQ:AGNC), Hatteras Financial (NYSE:HTS), Anworth Mortgage (NYSE:ANH), and Capstead Mortgage (NYSE:CMO). Price data is based on Yahoo, yield data is based on SEC filings and company releases indicating most recent dividends.

Price 6/15/11 Price 3/4/12 Yield
ARR $7.65 $6.68 14.4%
CYS $13.15 $11.88 13.6%
NLY $18.39 $15.41 11.8%
AGNC $30.39 $31.91 15.8%
HTS $28.89 $26.72 10.5%
ANH $7.25 $6.05 9.9%
CMO $13.65 $12.48 9.6%

As a general matter, AMREITs have not done well. There have been some dividend cuts and prices have generally declined although AGNC has held up well. It appears that AGNC has done better at avoiding prepayment risk than some of the others but it too may face this risk going forward. I cannot go into the details of the portfolio strategy and the hedging strategy of each of these seven companies in this article and there are other articles on Seeking Alpha which delve into these matters in more detail. The companies are reasonably transparent and an investor can develop a sense of comparative risk by reviewing quarterly financial statements which reveal the percentages of fixed and floating rate mortgages, prepayment rates and other critical details.

The important point I want to make here is a comparative one. AMREITs do not have an inherent tendency to increase in price or yield over time and, in that sense, have a major long term disadvantage when compared with typical equities. They cannot retain very much of their earnings and they are, in a real sense, comparable to closed end bond funds. As time passes, the huge dividends generated by a group of these stocks will tend to outweigh periodic fluctuations in price but investors cannot count on price appreciation over time.

Dividends will also fluctuate over time and can go down as easily as they can go up. NLY's dividend has declined from 57 cents a share in the fourth quarter of 2011 to 45 cents a share in the most recent quarter. In this sense, the sector has a disadvantage in comparison with, for example, electric utilities which have a long term tendency to increase dividends.

On the plus side, these stocks pay high dividends and also perform relatively well during an economic downturn because of the absence of default risk. While the losses since June 2011 have been painful, they are like pinpricks in comparison to losses some investors incurred on BDCs, closed end high yield bond funds, and commercial mortgage REITs in 2008 and 2009. For example, NLY got down to $11.85 in October 2008 and bounced back fairly nicely. It actually never reached the low hit in late 2005 (likely due to concerns about rising interest rates). While it took a hit, the loss was comparatively small compared to some of the other stocks and sectors we will deal with in this series. There are many, many other financial stocks which faired much, much worse than NLY during the Panic. As a result, I still think that AMREITs have a place in a yield oriented portfolio but, as always, a careful investor should diversify so as not be subject to too much of any one kind of risk

Disclosure: I am long NLY, HTS, AGNC, CMO. 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.