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The mREITs sector rallied yesterday as the sectors ETF (NYSEARCA:REM) posted one day gains of 4.77%. While the stocks markets in general rallied after the release of encouraging data related to the U.S. labor markets and retail sales, the mREITs sector had its own reasons to celebrate the return of the green color. I believe the rally will be short-lived as volatility in the interest rates increases. Therefore, before making an investment decision in an mREIT, you should be aware of its future strategy. The remaining of the investment thesis will discuss the dividend upsets in the light of the encouraging macroeconomic data and its significance for the mREITs.

Breath of relief

The entire U.S. stock market rallied after the release of the encouraging jobless claims data and the upbeat retail sales figures. The release of data even overshadowed fears about Japan's growth. The mortgage REITs sector also took a breath of relief after being rocked by days of sell-offs. Leading the rally were CYS Investments (NYSE:CYS) and Western Asset Mortgage (NYSE:WMC) with 7.5% and 8.2% respective gains during the day. Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) reported 5.3% and 5.4% increases in their respective stock prices.

Reasons for the rally

I believe the reason behind the recent rally in mREITs is not the latest macroeconomic data, but it's the latest dividend announcements made by ARMOUR Residential (NYSE:ARR), JAVELIN Mortgage Investment (NYSE:JMI), Capstead Mortgage (NYSE:CMO), Two Harbors (NYSE:TWO) and CYS Investments.

In sharp contrast to popular opinion, ARMOUR Residential and JAVELIN Mortgage maintained their monthly dividend rate for the third quarter of the prior year, while Two Harbors reported a 3% decrease in its quarterly dividend rate for the second quarter. Capstead Mortgage and CYS Investments also maintained their dividends. For me, ARMOUR, JAVELIN and TWO's dividend announcements were an upset.

ARMOUR and JAVELIN, the two sister mREITs, were expected to report declines in their quarterly dividend rates, while analysts covering Two Harbors were hoping a dividend hike. The announcements made by ARMOUR and JAVELIN have overshadowed Two Harbors' encouraging investors to buy the stocks.

Why it will be short-lived?

I have reasons to believe that pressure on the mREITs sector will increase as the Fed finally decides to exit the Agency MBS markets. The recent economic data also points towards increased pressure. The Fed is waiting for the economy to pick up before it could finally halt the stimulus. Encouraging data like these will help the Fed accelerate its decision. Therefore, the volatility in the interest rates will increase soon. So, the encouraging economic data threatens the mREITs' rally.

A look into the future

With the rally expected to be short-lived, investors looking to expand their regular income must understand the future potential/ approach of each mREIT before making an investment decision.

ARMOUR and JAVELIN were ranked previously ranked as the worst and second worst performing mREITs amid the speculations about the QE unwinding. The future for ARMOUR is to deleverage and rebalance its portfolio to tilt towards non-agency securities. Its charter allows the company to include high yielding non-agency securities in its portfolio. The inclusion of non-Agency securities in the company's portfolio will provide support to the bottom line, while deleveraging could provide a cushion against book value fluctuations. JAVELIN needs to tile its portfolio towards the high yielding non-Agency securities. Currently, around 90% of its portfolio is composed of Agency securities. Since JAVELIN is already a hybrid, its charter allows room for non-Agency securities.

Capstead Mortgage and Two Harbors disappointed me when they could not report a hike in their dividends. Capstead is an Agency mREIT that is exclusively invested in adjustable rate securities. These securities adjust their coupon payments to the more current market rates, in order to reduce price fluctuations. Therefore, under the prevailing interest rate environment Capstead is poised to benefit twice. One, higher coupon on its securities as they adjust upwards to the prevailing higher rates within a shorter time period. Second, fewer fluctuations in the book value, as it's less sensitive to interest rate changes.

On the other hand, Two Harbors is a hybrid mREIT that offered complete diversification and remained one of Credit Suisse's top picks. The company can benefit from more hedges. It has already gone from over $2 billion long TBA position to over $2 billion short TBA positions during the current quarter.

Annaly Capital Management and American Capital Management are two of the largest and well managed Agency mREITs. American Capital recently announced the rebalancing of its investment portfolio and other corrective actions to better suit its portfolio for the current environment. It decided to reduce its exposure in the 30-year fixed rate security, while disclosing to actively manage its assets and hedges to produce active returns. Before, these measures, Credit Suisse expected a 20% dividend cut.

Annaly Capital will benefit from a variety of factors in the future that will both protect its book value and provide support to the bottom line. First, it's widely expected to save up to 18 bps in compensation expense as its management is externalized. Second, the CreXus Investment acquisition is providing Annaly with double-digit returns from the commercial MBS markets. These will support Annaly's bottom line, while relatively lower leverage and the presence of CRE loans will cushion book value fluctuations.

CYS Investments, another pure-play mREIT, reported dividends in line with the prior quarter's dividends. Going forward, CYS is expected to benefit from the excess capital its holding. This excess capital will shield the company's book value and income from the volatile interest rate environment. It's currently utilizing only 67% of its equity, while the rest maintained as excess capital for eventualities like MBS haircuts, prepayments, accrued interest rates and volatility in the MBS prices.

Conclusion

The primary reason behind the recent mREITs' rally was the unexpected dividend announcements, while the recent economic data also contributed. However, I believe the rally will be short-lived, and the investors looking to invest in mREITs must take their decisions after carefully analyzing the future strategy of these mREITs.

Source: mREITs Buyers Beware, Economic Data Threatens The Rally