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This article is aimed at providing income oriented investors with a portfolio with elevated dividend yield coupled with capital appreciation potential. I used a stock screener to short-list mortgage REITs for which the analysts have a buy or better recommendation. The specific criteria are as follows:

  1. Each of the mortgage REITs selected must offer a dividend yield of at least 10%.
  2. Each of the mortgage REITs must have buy or better consensus recommendation from the analyst covering it.

Using the above criteria and the stock screener, I arrived at the following mortgage REITs:

  1. America Capital Agency (NASDAQ:AGNC)
  2. Apollo Residential Mortgage (NYSE:AMTG)
  3. Armour Residential (NYSE:ARR)
  4. CYS Investments (NYSE:CYS)
  5. Invesco Mortgage Capital (NYSE:IVR)
  6. American Capital Mortgage Investment (NASDAQ:MTGE)

It is evident from the list above that mREITs shortlisted are from both Agency and hybrid mortgage REITs sectors. The remaining investment thesis will discuss the portfolio returns. It will also touch upon both Agency and hybrid mREITs sectors briefly.

The Portfolio

The portfolio is designed keeping in mind the prevailing ultra low interest rate environment, where the yield hungry investors have little opportunities to enhance their regular income. In an environment where the 10-year Treasuries are yielding 1.95%, this portfolio is yielding 13.5% in dividends coupled with 5.2% capital appreciation potential. Overall, the portfolio offers 18.7% in total returns.

Book

Value ($/Share)

Stock

Price ($/Share)

Consensus Target

Upside

Potential (%)

Dividend

Yield (%)

Total

Return (%)

AGNC

31.66

32.36

34.03

5.2%

15.5%

20.7%

AMTG

29.61

22.69

23.43

3.3%

12.3%

15.6%

ARR

7.31

6.34

7.25

14.4%

13.2%

27.6%

CYS

13.32

11.76

13.22

12.4%

10.9%

23.3%

IVR

20.85

21.95

22.38

2.0%

11.8%

13.8%

MTGE

25.74

25.12

27.47

9.4%

14.3%

23.7%

Portfolio

7.8%

13.0%

20.8%

Agency Mortgage REITs

Agency mortgage REITs suffered greatly at the hands of the easing conducted by the Fed. The Fed's QE3 in particular brought down mortgage rates to record lows, hurting the net interest rate spreads of Agency mortgage REITs during the third and fourth quarter of the prior year. Ultra low mortgage rates also accelerated prepayments causing amortization costs for Agency mortgage REITs to go up. However, it is widely believed that the situation has reversed. The 30-year and 15-year mortgage rates have climbed since the beginning of the year, causing the mortgage applications to decrease. Also, the refinancing activity has dropped. In the latest weekly survey conducted by the Mortgage Bankers Association, the Refinance Index fell 8% from the prior week. A 5% week over week decline was reported for the Refinance Index by MBA during the prior week's survey. Therefore, the amortization costs are coming down as refinancing declines. Also, the higher mortgage rates this year will expand Agency mortgage REITs' net interest rate spreads.

American Capital Agency, Armour Residential and CYS Investments are the Agency mortgage REITs being considered in this investment thesis. While the three are externally managed, they have different exposures to the types of Agency securities. American Capital Agency has large chunks of the 30-year fixed rate Agency residential mortgage backed security. It forms over 60% of the company's fourth quarter-end portfolio, followed by the 15-year RMBS at 35%. Around 77% of the entire portfolio is composed up of lower loan balance mortgages and loans originated under Home Affordable Refinance Program (HARP). This portfolio is considered to have prepayment protection attributes, which is why the company posted a CPR of 10% at the end of the fourth quarter. American Capital Agency posted a 21 bps increase in its fourth quarter net interest rate spread.

Around 56% of CYS Investments' investment portfolio is primarily invested in the 15-year fixed rate Agency paper, followed by hybrid ARMs at 19% and the 30-year fixed rate Agency paper at 18%. The company reported prepayment speeds of 17.6%, up 30 bps from the third quarter's prepayments. During the fourth quarter, the company's top line surged 4% sequentially, while the average asset yield of 1.97% plunged 28 bps.

Armour Residential reported insider buying by some of its top executives. On March 14th, the two CEOs and a director bought 31,300 shares reflecting their confidence in the company's future expansion. The company is trading close to its 10-year low price of $6.25. Armour is largely invested in hybrid adjustable rate, adjustable rate and fixed rate Agency residential mortgage backed securities.

Hybrid Mortgage REITs

Hybrid mortgage REITs invest in a combination of mortgage backed securities including Agency and non-Agency MBS. They remained the most attractive investment since the Fed started squeezing the net interest rate spreads of Agency mREITs through QE3. Among the hybrid mortgage REITs considered in the investment thesis are Apollo Residential Mortgage, Invesco Mortgage Capital, and American Capital Mortgage .

Apollo Residential Mortgage is an externally managed mREIT that has around $113 billion of assets that it manages. Much of its assets (86%) are Agency RMBS, while the remainder (14%) are non-Agency RMBS. Around 87% of the company's Agency holdings are the 30-year fixed rate securities, while the remainder is 15 - 20 year fixed rate securities. Since the company has high yielding non-Agency RMBS in its portfolio, it posted a 27% sequential increase in its interest income for the fourth quarter. While the average asset yield during the quarter remained flat at 3.4% compared to the previous quarter, the company's net interest income of 2.7% plunged 10 bps due to a surge in the cost of funds. The fourth quarter's bottom line was further compressed by higher operating costs and lower gain on sale of RMBS.

Invesco Mortgage Capital has large chunks of the 30-year fixed rate Agency RMBS. Around 69% of the company's fourth quarter end portfolio is invested in Agency paper, while 17% is invested in non-Agency MBS. It also has investments in commercial mortgage backed securities constituting 11% of the portfolio. The company enjoyed a strong fourth quarter as its interest income advanced 3.5% on higher interest-yielding assets. The quarter's earnings were well supported by 40% increase in Other Income. Invesco Mortgage also reported insider buying by its CEO during the month of March. The CEO added 8% to his stakes in the company.

American Capital Mortgage Investment is managed by the same team that manages American Capital Agency. American Capital Mortgage has a $7 billion investment portfolio at the end of the fourth quarter 92% of which is invested in fixed rate Agency residential mortgage backed securities, while the remainder is non-Agency RMBS. Within the Agency holdings, around 60% are the 30-year fixed rate securities, followed by the 15-year fixed rate Agency MSB at 31%. During the most recent quarter, American Capital Mortgage reported 12% increase in its income of $49.8 million on higher interest income. While the average asset yield during the quarter increased 11 bps, MTGE reported a 2 bps decline in its net interest rate spread due to a significant increase in the interest expense.

Conclusion

I recommend you to buy the above portfolio to benefit from its capital appreciation and elevated dividend yield.

Source: 6 mREITs With Buy Or Better Analyst Recommendations And 21% Potential Return

Additional disclosure: The article has been written by Equity Whisper's Financials Analyst. Equity Whisper is not receiving compensation for it (other than from Seeking Alpha). Equity Whisper has no business relationship with any company whose stock is mentioned in this article.