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I believe American Capital Agency (NASDAQ:AGNC) and ARMOUR Residential (NYSE:ARR) will be among the worst performing mREITs around the unwinding of the QE. The remainder of the investment thesis will look at the reasons why both these mREITs are expected to underperform their peers.

mREITs skydive

The Fed's intentions of tapering the stimulus efforts have increased interest rate volatility, causing the mREITs sector to skydive. In particular, ARMOUR and American Capital Agency are down 22.5% and 17.25%, respectively, over the past one month. Over the same time period, Annaly Capital Management (NYSE:NLY) is down 12%. Annaly happens to be the largest mREIT.

What went wrong with American Capital Agency?

Given the situation, I believe American Capital Agency is not prepared for the QE tapering. Therefore, it remains one of my least favorite mREITs. The direction of the book value and the coming quarter's core earnings are considered material for the company's board and investors. However, you should expect a significant drop in the company's book value, while a dividend cut cannot be ruled out. Therefore, I recommend investors stay away from American Capital Agency around the unwinding of the third round of easing.

Given the volatility in interest rates, the company's net interest income and its dividends are highly variable. In its latest SEC filings, the company reports that investors should expect a 4.3% drop in the coming quarter's interest income if the rates climb 50 bps. During the third quarter of 2005, Annaly Capital Management was forced to cut its dividends to $0.13 per share amid Fed's tightening. The dividends plunged from $0.36 per share in the prior quarter. I believe mREITs are twice more volatile than equity REITs from a total return perspective. Therefore, they are obviously more prone to dividend cuts.

The Fed's decision to prolong its easing for a longer period is the only positive stock price driver for American Capital Agency. This event should benefit the company as its portfolio spread widens due to the steepness in the current yield curve, resulting in an earnings and dividend boost. According to the SEC filings, the company can increase its coming quarter's net interest income if the rates drop 50 bps.

ARMOUR Residential

ARMOUR Residential has been rated by Bloomberg as the biggest loser amid the current speculations about the Fed's exit. The stock is down 23.5% since the beginning of the year leading the fall in the Bloomberg Index of 33 mREITs. Looking at the situation, ARMOUR Residential's co-CEO himself notes that retail investors can suffer quick losses, which is why mREITs may not be appropriate for individual investors.

Besides, AMROUR made recent purchases of new production MBS which perform better in a low interest environment. ARMOUR made these purchases after it raised more equity recently. These securities perform worse when the rates start climbing. Besides, ARMOUR's entire MBS portfolio is structured in a way that you can expect the company to report around a 4% plunge in its net interest income if the rates climb 50 bps.

Investment Thesis

American Capital Agency is currently trading at 12% discount to its first quarter book value, which is in sharp contrast to the moderate premium at which the stock has been trading over the past few months. While American Capital is undervalued, the lack of positive stock price drivers makes me bearish on the stock.

ARMOUR Residential is changing hands at a significant 32% discount to its book value. This is also in contrast to the moderate premium at which the stock has generally traded at. The structure of the company's portfolio and the lack of positive stock price drivers make me bearish on ARMOUR Residential.

Source: American Capital Agency Among The Worst mREITs

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.