Why Don't mREIT Dividends Go Up When Rates Go Up?

| About: VanEck Vectors (MORT)

Why don't mREIT (NYSEARCA:MORT) dividends go up when rates go up? This is a common doubt. Most mREIT investors think that the sector develops as follows:

If long rates go down, spreads between the short-term financing mREITs use and the yields on the MBS paper they buy narrow. As spreads narrow, at some point the mREITs have to cut dividends. On the other hand, as long rates go down, the prices for the MBS the mREITs hold goes up, so book value goes up;

If long rates go up, spreads between the short-term financing and the yields on the MBS paper grow larger. As spreads grow larger, at some point the mREITs could possibly increase dividends as they ought to turn more profitable, even if their book value would be going down.

Yet, as commenter Tack says here, this is not what history teaches us:

This all sounds good in theory, but in practice the results are documented to be different.

Go take a look at various mREITs during the last rising-rate period, June 2003 - June 2006. What you will find is plummeting mREIT prices accompanied by dividend cuts, despite theory that spreads should expand profits. Annaly (NYSE:NLY), for example, fell from $20/share to $11.50, and dividends went from $0.45/share to $0.13/share. MFA Financial (NYSE:MFA) went from $10.60/share to $5.75/share, and dividends went from $0.28/share to $0.05/share.

Why does this apparent contradiction happen?

There is obviously a reason. And the reason is rather mechanical, stemming from the way mREITs work.

During a time when rates are rising, the values of the MBS the mREITs hold is declining. At the same time, the value of the financing is staying the same, and the book value of the mREITs is declining. This also has the effect of increasing the effective leverage of the portfolio held by the mREITs.

In this increase in leverage lies the problem. Given that risk is increasing, the mREITs will be either keeping the portfolio at the same size, or more likely reducing it - that is, selling MBS. Now, to have access to the new, larger, spreads, the mREITs would have to be buying new MBS at the higher rates, not sitting quiet or reducing exposure.

Additionally, as rates go up, refinancing activity quickly plunges. This too means that the MBS the mREITs hold don't pay off sooner. So they're not replaced, so the mREIT has no access to the new, larger, spreads.

Finally, as the mREITs are forced to reduce leverage, not only are they not accessing the new, larger, spreads on newly bought MBS, but they're also seeing fewer gains from a volume effect. That is, they're still investing at the old spread, and now they have fewer assets to gather/carry in absolute terms.

In short, in a scenario of rising rates the mREITs do not have access to the higher spreads, and if rates go up enough, the mREITs are even forced to explore existing spreads with less volume.

When does this end?

The process I described does have an ending. When rates stabilize or head lower again, the mREITs slowly gather capital from maturing debt or newly-increased refinancing activity to take advantage of the now-larger spreads. Additionally, as the panic subsides it becomes easier to get fresh capital for the mREITs to leverage at the higher prevailing spreads.

Additionally, any new mREITs being launched in an environment of higher spreads, can immediately take advantage of them.

Conclusion

While intuitively it would seem that higher rates could lead to higher spreads and thus higher dividends, the truth is that the dynamics which take place in an environment of higher rates do not allow existing mREITs to take advantage of the higher spreads.

A pressure to reduce leverage, along with a drop in refinancing activity, means that existing mREITs cannot buy new MBS when rates are going up, and thus cannot use the higher spreads. This in turn can easily mean that instead of higher dividends, shareholders actually see lower dividends as observed in practice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.