Are High Yielding aMREITs Ready to Run?

Agency mortgage backed real estate investment trusts, or aMREITs, are an often overlooked sub-industry in the MREIT industry and are showing recent divergence from the S&P 500. There is good reason for this divergence given recent economic news on the underlying weak fundamentals of the U.S. economy and the underlying fundamentals in aMREITs.

What are aMREITs?

Many self directed investors do not understand aMREITs. Investors avoid aMREITs either because they are perceived as: [a] “risky” REITs, or [b] deal with even “riskier” mortgage backed securities, or [c] both. These perceptions of risk are wrong and here is why.

aMREITs are characterized by the following key traits:

1. aMREITs are not lenders and do not hold individual mortgages;

2. aMREITs are generally high yielding securities currently ranging from 13 to 25 percent non-qualified annual yield;

3. aMREITs invest solely or primarily in low-risk agency paper (Fannie Mae, Freddie Mac, VA, FHA) backed by the U.S. government;

4. aMREITs take advantage of the upward sloping shape of the yield curve, borrowing on a low-cost short term basis and investing in high-yielding, long term securities and generally have a net interest margin of 2 to 4 percentage points.

5. aMREITs borrow to apply leverage (4x to 10x) to the net interest margin to produce earnings and dividends.

6. aMREITs are organized as REITs and under U.S. tax law, they must pay out more than 90 percent of their earnings to retain REIT tax advantages.

7. aMREIT secondary offerings are generally accretive, not dilutive, as companies opportunistically take advantage of wider net interest margins and higher leverage.

aMREITs are a sub-group of the MREIT industry that eliminate credit risk by investing in U.S. government backed securities issued by Fannie Mae (FNM), Freddie Mac (FRE), and others. Eliminating credit risk is a good thing.

aMREITs generally pay in excess of a 10 percent non-qualified dividend. High yield is a good thing.

So, what are the risks?

One risk is that the yield curve will become less steep once the economy recovers and the Federal Reserve begins to raise the Fed Funds rate. This would reduce the net interest margin.

Funding risk—especially for highly leveraged aMREITs—is also a possibility via a failure in the short term borrowing market.

aMREITs Pay High Dividends

There are six companies I follow in the aMREIT sub-industry. They are American Capital Agency (AGNC), Annaly Capital Management (NLY), Anworth Mortgage Asset (ANH), Capstead Mortgage (CMO), Hatteras Financial (HTS), and MFA Financial (MFA).

Each company is managed a little differently from the others. For example, each has a slight variation on the general theme of investing in low-risk, long term securities. As a case in point, ANH invests largely in securities characterized by adjustable rate mortgages and is subject to re-financing risk when initial rates begin to adjust. On the other hand, AGNC invests in longer term fixed rate mortgages and could be disadvantaged in a rising long bond environment.

As a first start at due diligence, the following table provides current yield metrics based on most recently quarterly dividend announcements and ranked by market capitalization for six aMREITs as of mid-day June 26, 2009.

Ticker	Market Cap (millions of $)	Yield
NLY	$8,110	16.0%
MFA	$1,480	13.3%
HTS	$1,020	15.7%
CMO	$796	17.9%
ANH	$723	16.8%
AGNC	$354	25.3%

Source: Self Directed Investor, Inc.

The table is useful as a first look at comparing these companies. But it can be misleading for several reasons. For example, the quality of earnings and therefore future dividend yield differ by company. Another disconnect in the comparison table above is that ANH and MFA haven’t declared their second quarter dividends. The other companies recently declared second quarter dividends.

Divergence from S&P 500 Benchmark

A divergence between aMREITs and the S&P 500 index ETF (SPY) has developed over the past couple of weeks as illustrated by the chart below. The green line represents the six aMREITs listed above purchased in equal weights. The pink line is the SPY.

This divergence may just be noise.

On the other hand, recent bad economic news may be drawing new money into the aMREIT sector. A weakened economy makes it less likely that the Fed will raise the Fed Funds rate. As a result, investors likely perceive the current upward sloping yield curve as enduring for some time. To borrow a popular term, if the “green shoots” are turning into “brown stalks,” aMREITs are likely to continue paying high yields. In fact, many aMREITs are underleveraged compared to past economic cycles and could take advantage of a weak economy by increasing leverage.

Self directed investors willing to manage the risk of a flattening yield curve and able to tolerate “funding risk” may want to look more closely at aMREITs. If the economy remains weak, I don’t expect these relatively low valuations to last much longer.

Full Disclosure: Long AGNC, NLY, ANH, CMO.

Comments

[whisperonth...:]

Even with the additional tax work at tax time - and I like doing my own because it helps me understand where my money comes from and where it goes - I love NLY and AGNC. Now I have a few more to look into. Thanks!

Jun 28 08:18 AM

[YoYoMama:]

ANH is the least leveraged of the lot.

Jun 28 08:51 AM

[whisperonth...:]

Good to know, gives me a starting point. Thanks, YoYo.

Jun 28 09:02 AM

[David Van K...:]

Very good article, thanks. I am not an expert in aMREITS, but while I was reading the description of what they invest in, and considering myself as a possible investor in them, I couldn't help but think that this is the same kind of thing that blew up for so many banks and led to the banking/financial crisis we are in right now: Leveraged bets on packages of mortgage-backed securities with hard-to-believe returns.

Jun 28 09:09 AM

[Patrick Harden:]

Great overview of the agency-backed mREITs. While this group as a whole has become more expensive of late, the high dividend yields are fully sustainable as long as the yield curve remains steeply sloped. Empirical evidence of the aMREIT success has come in the large number of copycats that have or will come public (e.g. Cypress Sharpridge - CYS, Invesco Mortgage Capital - IVR).

However, it is worth doing some digging to find out which of these companies is best for your portfolio. For example, American Capital Agency (AGNC) has a questionable external sponsor in struggling BDC American Capital Ltd. (ACAS), while Annaly Capital (NLY) seems to be adding on extra risk by venturing into non-agency MBS through its investments in Chimera Investment (CIM) and recently created CreXus (CXI), which filed an S-11 on Friday.

Glad to see this group of stocks getting some much-deserved attention and clarification.

Jun 28 10:32 AM

[Eye Forget:]

Other should understand this is one person's opinion of something he admittedly does not understand. One might ask the question how an investment with the implicit guarantee of the USG can blowup. A rather simple question that appears absent from this comment.


On Jun 28 09:09 AM David Van Knapp wrote:

> Very good article, thanks. I am not an expert in aMREITS, but while
> I was reading the description of what they invest in, and considering
> myself as a possible investor in them, I couldn't help but think
> that this is the same kind of thing that blew up for so many banks
> and led to the banking/financial crisis we are in right now: Leveraged
> bets on packages of mortgage-backed securities with hard-to-believe
> returns.

Jun 28 11:27 AM

[Eye Forget:]

"manage the risk of a flattening yield curve"

This is the key to dividend security in these stocks. My belief is the yield curve will widen in the near-term and begin to flatten later. However, even once it flattens, there will be an unusually high spread remaining.

The short end will remain low as long as the economy is sluggish and there are concerns about any deflation. The long end will come under increasing pressure as China redirects it excess funds internally and the Fed starts printing more money (as they are the only buyer left than can fund the deficits).

Good article.

Jun 28 11:34 AM

[ansoncom:]

Nice article. Where have I heard of amreits before? Hmmmmm.

Jun 28 12:05 PM

[Old Trader:]

While an interesting article, I'm struck by the recollection of what caused the S&L debacle, years ago; the mismatch in duration (borrowing short, while lending long). I'm not certain I'd interested in wading into an area where everything depends on the continuation of the status quo in interest rates.

Jun 28 01:58 PM

[Alan Young:]

Good article! I already own three of these, based on dividend-yield screening and cursory research, but you have added some nuance to my understanding.

Jun 28 01:58 PM

[WKMA:]

read about HTS in Barrons last October ('08) in the marketwatch section, an article writte by M. Fleming.
HTS is 100% backed by the U.S. governemnt just like ginnie mae. Figure the return...HTS at about $15 & compute the % in the asking price? Also, look at HYF & NYMT....NYNT has jumped from about $2.5 to $5 in 2 months.
On yahoo, U can do comparisons.
W.K.A. (Chicago)

Jun 28 02:05 PM

[dvlatas:]

There are three types of Mreits. The kind that bundle mortgages and sell them as securities (ABS or MBS) – fannie and freddie; The kind that buys these ABS or MBS – the aMreits; and the Hybrid, the kind that does both.

The aMREITS you describe are the buyers of securities created by others. They essentially, are bond funds dealing in ABS or MBS created by Fannie, Freddie etc. The reason Fannie and Freddie are wards of the state, is because they bought mortgages to package. The demand for mortgages to package was so great that a bunch of bogus mortgages were created, sold to packagers who bundled them up to sell to the aMREITS and others. The credit risk has now been remeoved, because Fannie and Freddy are wards of the state.

The risk to the aMREITS is interest rate fluctuations. They borrow short term money to buy ABS or MBS which yield much more than the interest they pay on their loans. After they buy these securities, they leverage by using what they bought as collateral to borrow even more ABS or MBS. I haven't checked recently, but some of them had up to 10 times leverage on their money, etc.

When the cost of borrowing exceeds the yields on the securities held, the aMreits have a problem, and even the better ones sometimes explode.

Caveat Emptor!

Jun 28 02:38 PM

[Augustus:]

The MREITs referrenced invest in govt. guaranteed mortgages. They are not Thornburg. They can have the funding problem though. The guaranteed interest rate of 5% on the investments will not look so good if the cost of funds to carry the MBS becomes 6%. That is what happened to the S&L's in the late 70's. It took them out. This is a fairly simple business. It still has dangers.


On Jun 28 09:09 AM David Van Knapp wrote:

> Very good article, thanks. I am not an expert in aMREITS, but while
> I was reading the description of what they invest in, and considering
> myself as a possible investor in them, I couldn't help but think
> that this is the same kind of thing that blew up for so many banks
> and led to the banking/financial crisis we are in right now: Leveraged
> bets on packages of mortgage-backed securities with hard-to-believe
> returns.

Jun 28 11:39 PM

[SML:]

Consider hedging these to the downside with Puts if you're worried.

Jul 09 10:17 PM