Agency-backed mREITs have attracted a very wide range of investors due to their perceived low risk and high yields. The bright glare of double digit yields and the touted safety achieved by focusing on agency backed mortgage investments may be blinding the unquestioning investor from the darker reality of total returns, risk of leveraged interest rate spreads, and declining spreads with portfolio turnover due to increased competition of more players in the field, including the insatiable Fed and QE-infinity.
Names and tickers such as Annaly Capital Management (NLY), American Capital Agency (AGNC), Anworth Mortgage Asset (ANH), Hatteras Financial (HTS), Apollo Residential Mortgage (AMTG), Capstead Mortgage (CMO), MFA Financial (MFA), Armour Residential REIT (ARR), Invesco Mortgage Capital (IVR), Chimera Investment (CIM), and CYS Investments (CYS) have become a part of many portfolios either by direct investment or indirectly as holdings in ETFs, Mutual funds, or other managed portfolios. In this article, I take a brief look at the performance of each beyond distribution yield.
Do not let the flash and glitter of high dividend yields hypnotize you into failing to evaluate the overall quality of the performance. Distribution yield is only part of the picture of total return. Only when you take the total return of share price performance with distribution gains can you assess the actual performance.
Likewise, the safety of agency backing of the underlying securities in the mREIT portfolio is not the only factor determining risk nor is it the primary risk factor. Focusing on this single risk aspect is a distraction from the total risk picture. Look beyond mortgage portfolio guarantees to evaluate the risk of leveraged interest rate spreads, and declining spreads with portfolio turnover.
To decide if agency mREITs are right for you, consider your investment goals and the historic performance of this group as well as historic and anticipated future outlook for your individual investment choices.
First, let's take a look at the distribution yields for this group. Several things stand out on this chart. First, the average yield centering around 15.0% since the financial crisis of 2008 is the feature that draws most people's attention initially. These high yields reflect the spread in rates between mortgage portfolio yield and cost of borrowing.
Along with this eye catching trend, you will also note the wider general spread that shows these yields range between 10% and 20% (and beyond). Two factors influencing this spread are the degree of leverage employed by the mREIT and the company's cost of funds.
Leverage is a choice of each management style and strategy. Generally, Annaly maintains a relatively low leverage and Chimera uses a more aggressive, higher leverage. The larger leverage shows a history of more volatility in yield along with greater absolute yield extremes to both the high side and low side. NLY's lower leverage exhibits a less volatile range and more limited absolute return. This is a good example of the hidden risks and rewards beyond just the mortgage spreads and agency guarantees for mortgage.
Cost of funds varies from company to company due to many factors, including overall size, method of funding (debt, equity offering, degree of leveraging), key ratios such as debt ratio, return on assets, return on equity, and others, management and performance history, and other related factors.
Next, we see that most of the companies maintain their relative position within the wide spread of yields. Along with that observation is the converse fact that a few of the companies demonstrate a high range of yield volatility, moving from the lower parts of the spread to the highest (and back down again in many cases). Again, this volatility of individual company performance is primarily a reflection of leveraging strategy. Of course, yield volatility is also both a cause of and result of share price volatility.
There are a few subtler observations a careful eye will also pick out from the chart. Only 4 of the 11 companies trace a history back to prior to the 2008 financial crisis, with the remaining 7 being all relative newcomers.
Interestingly, the 4 companies with a pre-2008 history foretold the financial crisis in advance. The yield for each of them began rising significantly by the opening of 2008 and rose ever faster as the crisis broke upon the investment markets finally in September 2008. This is not merely a historic curiosity. It is a reflection of the sensitivity to market liquidity, cost of funds, and spreads. As such, the historic harbinger of financial instability is a lesson that investors need to watch trends of these 3 factors closely when contemplating future performance expectations. Of course, it is also a valuable tool for monitoring the health of financial markets in general.
A close examination shows that although changes in yield are partly an inverse reflection of share price movement, there are also periods where yield is actually changing while share price remains fairly stable.
Annaly for example clearly shows the sharp inverse moves of share price vs. effective yield that is almost all due to share price move and not to changes in distribution yield. At the same time, larger trends reflecting changes in dividend yield beyond correlation to share price are clearly seen. Share price from mid 2008 through the first quarter of 2009 average flat while yield advanced from 12% to over 16%. Likewise, we see increasing yield with stable share price from mid third quarter 2009 through the 1st quarter 2010. Declining yields against a background of stable share prices are seen from mid 2010 through mid 2011. Most recently, we see a rapidly declining yield accompanied by a decline in share prices, a clear signal that this share decline is caused by falling distributions.
In the case of Anworth, the pattern of rising distributions raising effective yield and share price is very clear. Distributions and effective yield rise rapidly in 2008 while prices are stable and continue to provide a 14% effective yield even as share prices surged. Yield continued to remain steady above 16% as share prices advanced 50% from about $12 per share to over $18. The 2010 through late 2012 decline in yields has been against a background of flat to declining share price trends and is clearly decoupled from primarily reflecting the mathematical inverse relation to share price alone. ANH does not show the combined drop in share price together with yield in the past week that NLY demonstrates. This is an indicator that the issues in NLY are internal to it and company specific rather than an industry trend. Anworth price and yield are strongly correlated to its distributions. At this time, price and yield appear to be adjusted well to declining distributions.
Capstead Mortgage exhibits strongly attenuated downward moves in yield compared to share price change. This affirms yield change is more dependent on actual distribution changes than merely the inverse mathematic relation of a fixed distribution compared to changing share price. Again, the lack of correlated downward movement of yield and price for the past week affirms the NLY move is an internal issue for Annaly and not a macro environment issue. Capstead's advancing share price in the face of declining distributions suggests growing pressure for rapid decrease in share prices.
MFA Financial shows a strong correlation of share price driven by distribution resulting in a relatively stable effective yield rate. The steeply advancing share price against a background of sharply declining distributions coupled with declining yield rates suggests a very strong downward share price move is overdue.
These few examples show how an investor needs to look beyond the simple lure of yield and compare price, distribution and yield together with their trends to establish a basis for understanding value. I will not take the space here to continue such a review for the 7 other mREITs discussed since the data is readily available to investors for their own analysis. Instead, I will present some examples of looking to total return of share price and distributions as another step needed to filter past the glitter of high dividend yields alone.
We begin a look at total return using American Capital Agency for an example. The company boasts a fairly steady distribution showing a falling yield based on advancing share price. This would appear to be much of the best of all worlds. Steady high yield income and share price appreciation. Just what an investor craves.
The addition of a look at the total return for share price taken together with dividends paid will reveal if all the glitter is gold. This chart shows an Alpha performance of 304.7% return over 5 years with a steady performance and low volatility. Put AGNC in the winner column.
Contrast that with industry leader Annaly Capital Management and its total return chart as shown below. In this case, NLY has performed reasonably well but with greater volatility and less than 1/3 the total return of AGNC. Part of this is due to the more conservative approach of Annaly management using lower leverage generally. The individual investor will have to determine if the increased leverage risk is suitable for the increased returns AGNC has historically offered. Label NLY a winner also.
Chimera by contrast has been a major disappointment. At first glance, its 12.2% yield on a price that has been basically overall flat since 2009 might seem like a conservative and reasonable investment with potential for considerable upside price appreciation as it showed historically for 2010 and into early 2011. The advancing price against the trend of falling distributions and yields is not a good sign however. Total return for the 4 year period is also a disappointment at only 121.3%. Walk on past CIM.
Total Return comparisons for HTS, CYS, ARR and IVR are provided in the chart below. In general, the returns shown are not as attractive as alternatives discussed above.
- High yield agency-backed mREITs must be examined carefully to understand the real yield and risks.
- The current outlook for this industry segment is continued shrinking spreads and greater competition for new mortgage portfolios as existing holdings mature or are otherwise disposed of.
- These company holdings are often described as risk free because the full faith and credit of the United States Government stands behind the underlying mortgage principal. However, considerable risk in leveraged debt, sources and cost of new debt, and competition for funding and portfolio mortgages provides a lot of risk beyond the mortgage capital guarantee.
- Select companies still offer attractive yields which may be appropriate to investors on a case by case basis. You must examine your own criteria and goals for risk, return, and volatility to determine what place and to what extent these securities belong in your portfolio.
- Of the companies reviewed, AGNC stands out as a possible buy.
- NLY has attractive historical performance and is virtually the inventor of this type of investment structure. It has an excellent management and conservative approach. However, price moves of the past week are disturbing and suggest further analysis is needed before investing in it at this time.
- CIM and MFA are on my avoid list.
Disclaimer: I am not a licensed securities dealer or advisor. The views here are solely my own and should not be considered or used for investment advice. As always, individuals should determine the suitability for their own situation and perform their own due diligence before making any investment.