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The tremendous volatility in the interest rates due to the Fed's decision to exit the Agency MBS markets have hurt the mortgage REITs sector so much that some of the most well-managed and largest mortgage REITs were forced to cut their dividends. The latest is the announcement made by Annaly Capital Management (NYSE:NLY), the largest mortgage REIT.

Mortgage Market Update

Since the start of the speculations about the Fed's exit, the mortgage rates started climbing along with Treasury yields. The 30-year fixed mortgage rate has gone up 44 bps since the start of this quarter, while the 15-year fixed rate is up 36 bps over the same time period. At the same time, the 10-year Treasury yield went up 34 bps to 2.43%.

It is visible from the chart below that the yield curve had steepened since mid May when the speculations about the Fed's exit first erupted.


(Click to enlarge)

Higher mortgage rates and a steep yield curve cause the mortgage REITs to expand their spread. However, at the same time, higher rates and the increased volatility in the rates cause erosion in their book values. The expansion in the spread occurs in the long run, while the immediate term effect is the decline in the book values.

The skydiving continues

The Fed's announcement about the final unwinding of QE is still confusing as it's still linked to improvements in the macroeconomic conditions, which continue to give mixed signals. Therefore, I believe the volatility in the mortgage markets will increase further, causing the mortgage REITs to skydive further.

This quarter's decline in the mortgage REITs is already the highest since 2008. Annaly Capital Management, American Capital Agency (NASDAQ:AGNC) and ARMOUR Residential (NYSE:ARR) have declined 18.25%, 25.5% and 18.2%, respectively, since the start of the current quarter.

Bloomberg reports, mREITs are down partly because the agency MBS purchased by agency mREITs have gone down even worse than Treasuries, negating their attempts to hedge against rising interest rates.

Annaly Capital joins the club

After American Capital Agency, Annaly Capital Management became the latest victim of the volatility in interest rates. Annaly, too, was forced to cut its second quarter's dividend to $0.40 per share, down 11% from the first quarter. This was in contrast to the popular opinion that Annaly Capital would be able to maintain its first quarter dividend distribution in the second quarter.

Annaly Capital had a number of positive drivers that I believe would enhance the company's earnings potential and at the same time protect its book value. The company is scheduled to report its second quarter earnings on July 29, 2013. I believe Annaly Capital will report lower management/compensation expense due to the externalization of its management. Lower compensation expense will provide support to the bottom line, while the top line will be supported with the low double-digit returns available from the commercial MBS markets through Annaly's recent acquisition of CreXus Investments. I also believe Annaly Capital will be among the Agency mREITs that will report the lowest decline in its book value. That's because of the presence of CRE loans in its portfolio and the relatively fewer level of leverage in its capital structure.

American Capital slashes dividends

American Capital Agency, the second largest Agency mREIT also reported a 16.6% decline in its quarterly dividend when it declared the second quarter dividend. American Capital has been among the agency mREITs that suffered the most because of the rise in interest rates.

So, it took some corrective actions, including the active management of its assets and hedges and a reduction in the 30-year fixed rate MBS. These were aimed at making the company's book value less sensitive to changes in interest rates.

However, the actions didn't help, and the analysts at Barclays were forced to cut its ratings to equal weight on concerns of book value erosion and lower earnings potential.

ARMOUR Residential, the odd one out

Among the larger agency mREITs, ARMOUR Residential is the odd one out. It announced that it would pay a monthly dividend of $0.07 per share, in line with its previous dividends. However, the company still faces lack of positive earning drivers. Its newly purchased MBS perform worse during rising interest rates.

Looking at the situation, analysts at Barclays downgraded ARMOUR Residential.

Conclusion

The agency mortgage REITs sector remains the biggest loser around the unwinding of the third round of easing. Despite the dividend cut, Annaly Capital Management has the strongest earnings potential, among the aforementioned mREITs. Therefore, I am bullish on it and recommend investors stay away from ARMOUR Residential.

Source: Annaly Capital Joins The Club, Armour Is The Odd One Out