With the recent fears of pressure on mortgage real estate investment trusts (REITs) due to fears of increasing rates that would diminish profit margins, I have begun to share my thoughts on the space. Recall that a REIT is simply any corporation, trust or association that acts as an investment agent specializing in real estate and real estate mortgages under Internal Revenue Code section 856. The rules for federal income taxation of REITs are found primarily in Part II (sections 856 through 859) of subchapter M of chapter 1 of the Internal Revenue Code. The advantage of being a REIT is that the company is entitled to deduct dividends paid to its owners, and thus a REIT may avoid incurring all or part of its liabilities for U.S. federal income tax. To meet the qualifications, REITs are required to distribute 90% of their earnings to shareholders. A mortgage REIT is primarily a company that makes its profits in either the residential and/or commercial mortgage market (generally by buying long-term bonds and issuing short-term higher interest loans). In this article, I discuss what I have done with my favorite mortgage REIT, American Capital Agency since it reported earnings.
American Capital Earnings for Q1
Following American Capital's (AGNC) dismal quarterly performance, I have been on a hunt for a potential replacement for this beloved dividend paying behemoth. In AGNC's earnings report there were quite a few worrisome details. In fact, it was essentially its worst ever quarter. For the first quarter, it reported comprehensive loss per common share of $1.57. This included $0.64 net income per share with a $2.21 loss per common share in other comprehensive areas (such as unrealized losses on investments). AGNC also reported a $0.78 net income spread per share (that is, the income made after cost of borrowing, expenses and interest income). The book value of the company dipped 9% to $28.93, down from $31.64 at the end of 2012. Its total economic return, which is calculated by taking the dividends paid plus the change in book value, was a loss of $1.46 per share, or 4.6% for the quarter. Much of the losses came from $837 million (about $2.20 per share) of unrealized losses on agency securities. AGNC had realized losses of $26 million related to the sale of agency securities. In addition, AGNC realized about $0.55 per share in losses related to the recognition of tax during the quarter. One positive however, is that in the earnings report above, AGNC President Gary Kain noted that interest rates dropped again in April and May, which could allow the company to acquire assets at attractive prices. Still, the quarter was miserable.
Considering Selling AGNC or Diversifying Out to Other Mortgage REIT Stocks
In searching for a replacement I wrote an article detailing that I stumbled across a few hybrid REITs that I was considering, which I thought may offer investors better diversification as well as the potential for sustained and/or increasing dividends. To recap very briefly, a hybrid REIT is different than a standard REIT generally on how it invests. Mortgage REITs typically focus on agency strategies. Agency REITs carry limited credit risk as securities are guaranteed by government-sponsored entities. Agency REITs are subject to interest rate and refinance risk. As opposed to agency REITs, hybrid REITs invest in both agency and non-agency securities. Hybrid REIT managers have the flexibility to move between agency and non-agency securities to find the best risk/reward for shareholders. Purchased at the appropriate price, non-agency securities can offer REIT investors attractive risk adjusted returns and lower the volatility in a REIT portfolio. Non-agency mortgages trade more like equity than credit as when the economy heals, recoveries increase. As the economy heals, the market drives interest rates up, which hurt agency securities. The three REITs that I examined were Western Asset Mortgage (WMC), New York Mortgage Trust (NYMT) and Apollo Residential Mortgage (AMTG). The purpose of this article is to discuss WMC's earnings that were just reported (5/15) and come to a decision relative to its potential place in my portfolio relative to AGNC.
As it stands now, WMC is currently offering an approximate 19.5% dividend yield if it maintains its last quarterly dividend of $0.95 per share. The company has a diverse asset mix consisting of residential mortgage backed securities, asset backed securities and commercial mortgage backed securities. Additionally, since the company is technically a hybrid mortgage REIT, it also invests in non-Agency RMBS (though contains mostly agency RMBS). Therefore, WMC may offer a bit more diversification than AGNC.
Examining WMC 4th Quarter Earnings
The company reported earnings per share of $1.05, $0.18 per share ahead of what analysts were expecting. It also reported a 7 basis point increase in its asset yields during the fourth quarter. At the same time its net interest rate spread increased 5 basis points when most of its peers were reporting contractions in their spreads due to the government's aggressive bond buying. The net income for the quarter was approximately $24.8 million or $1.04 per weighted average diluted share. WMC's core earnings, which is a non-GAAP number defined as net income excluding net realized and unrealized gains and losses on investments, net unrealized gains and losses on derivative contracts and non-cash stock-based compensation expense, was approximately $25.1 million or $1.05 per diluted share. WMC's net interest income for the period was approximately $30.6 million. This number is a GAAP number and does not include the interest we received from IO securities or treated as derivatives. It also does not take into account the cost of interest rate swaps both of which are included in the gain loss on derivatives instruments line in its income statement.
On a non-GAAP basis, net interest income including the interest received from IO securities treated as derivatives and taking into account the cost of hedging was approximately $28.2 million. Included in this calculation was an approximately $55.6 million coupon interest offset by approximately 18.1 million of net premium amortization and discount accretion. The weighted average net interest spread for the quarter which takes into account the interest received from IO securities as well as the fully hedged cost of financing was 2.05%, reflecting a 2.86% gross yield on the portfolio and a 0.81% effective cost of funds. Finally, operating expenses for the quarter were approximately $3.2 million, which include approximately 1.3 million of general and administrative expenses and approximately 1.9 million in management fees. In addition to core earnings, WMC also had approximately $12.6 million of net realized gains as a result of modest repositioning of the portfolio, which were offset by $10.9 million of realized losses on interest rate swap as we terminated some agreements early and entered into longer-dated swaps in a move to extend the duration of its liabilities.
1st Quarter Earnings, Weaker Than Expected, Much Like AGNC's Report
WMC's report was pretty gloomy. I was expecting better myself. The stock got punished for a big 8% loss on the news. There was a lot to be desired, but also some bright spots. First off, WMC reported a net loss of $28.5 million, or $1.18 per share. Included in the net loss was $54.8 million of net unrealized loss on RMBS and other securities, $13.9 million of net realized loss on RMBS and other securities (including other loss on residential mortgage-backed securities of $2.3 million), and $15.4 million of net gain on derivative instruments and linked transactions. These unrealized losses were high, similar to AGNC's report. In Q1 WMC generated core earnings of $22.6 million, or $0.93 per basic and diluted share. Net interest income for the period was $28.6 million. WMC's weighted average yield on its portfolio was 3.04%, including its agency RMBS, interest from agency IO securities accounted for as derivatives, and non-agency RMBS (including linked transactions). WMC's effective cost of funds on its agency and non-agency RMBS financing (including the cost of interest rate swaps and linked transactions) was 0.87%. The annualized net interest spread on its portfolio was 2.17%, including agency RMBS, interest from agency IO securities accounted for as derivatives, and non-agency RMBS (including linked transactions) and taking into account the cost of the interest rate swaps.
Similar to AGNC's President Gary Kain, WMC CEO Gavin James spoke to some of the weakness in Q1 being attributable to interest rate changes, likely to be due to a belief Federal Reserve QE would end sooner than expected. He stated " during the first quarter of 2013, asset prices in the Agency RMBS market were influenced by a belief that QE3 monetary policy would end sooner than expected, causing mortgage spreads to widen and pay-ups on call-protected securities to decline. Given the composition of our portfolio, which reflects our belief that QE3 will continue for the foreseeable future, the moves in asset prices resulted in a decline in book value during the first quarter. The market has since realized that it was premature in its view of a near-term reduction in QE3, which has resulted in a partial recovery of the book value lost during the first quarter, as spreads have narrowed and pay-ups on call-protected securities have increased since March 31, 2013." The comments to me are quite bullish for the mortgage REITs. Considering they have been battered because of weak Q1 reports, the loss in the stocks may be presenting a buying opportunity.
So Sell AGNC And Buy WMC, Hold AGNC and Buy WMC, Sell Both? What Will I do?
I tend to agree with management on what happened during Q1. I think the mortgage market during the first quarter needs to be kept in perspective. It seemed to be an anomaly for both companies. While AGNC has a much longer history to judge, WMC's performance reflected the same ills as AGNC's. In my opinion, this Q1 anomaly was the result of the market erroneously interpreting remarks from the Ben Bernanke and believing that QE3 would be coming to an end sooner than expected. While this may have only been the case for a few weeks during the quarter, it was likely enough to put downward pressure on asset prices and resulted in a declining net book value of the companies. Since the end Q1, the market has recognized that it was premature according to management of AGNC and this erroneous assessment of an early end to QE3 has since been alleviated. As a result, asset prices most likely have partially recovered and will continue to do so in the near future. It is quite possible AGNC and WMC have already seen some rebound in book value during the current quarter (Q2). The extreme volatility that has occurred in the Q1 reports should cause mortgage REIT investors some pause. While I believe the Fed will be accommodative for at least the rest of the year, any signs that the Fed will truly let off the gas pedal should be noted. When this happens, the mortgage REITs will suffer. However, for now the party will continue. So what am I going to do? I sold 25% of my AGNC position and took half of the proceeds and invested in WMC at $19.80. At current prices, it still trades at a premium to the new book value of $19.42 (it only dipped 10 cents after this gloomy quarter). The remaining half I am still debating on. I may hold the cash, wait till WMC dips below book value, or diversify further into either NYMT and/or AMTG. I will however detail what I do in a future article.
In summation, I am still long AGNC. I think it is a well run company and it has been very profitable for me over the years. However, the recent quarter was distressing. For now it seems to be a one-time event, but given that the economy is slowly starting to improve and rates are ticking upward, it is becoming harder and harder to just buy and hold these stocks. In an effort to diversify a little out of AGNC, I picked up WMC today after earnings. The issues of Q1 for AGNC we reiterated by WMC management. For now, I believe the space is safe until we hear confirmation of a tapering of QE by the Federal Reserve, as opposed to rumors.