ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (MORL) declared a monthly dividend of $0.0884 with an ex-date of September 11, 2013 and payable September 23, 2013. Declare may not be the correct word, since MORL management has no discretion in the manner as the dividends are simply a pass-through of the dividends declared by the mREITs that comprise the portfolio. The previous monthly dividend in August was $0.1062. However, as I explained in this article: 30% Yielding MORL, MORT And The mREITS: A Real World Application And Test Of Modern Portfolio Theory MORL pays widely varying dividends each month since most of the mREITs in the basket pay dividends quarterly on various schedules. ARMOUR Residential REIT Inc. (ARR) being one of the few mREITs in the basket that pays monthly. During any three-month period all of the components would have paid their dividends. Thus, the key comparison is with the $0.1263 dividend MORL paid in June. The September payment is a decline of 23.46% from June. Clearly the decline in mREIT dividends is accelerating.
The most important dividends come in the months of January, April, July and October. As I indicated earlier, I expected a reduction in MORL's July dividend relative to April since the two largest components of MORL, Annaly Capital (NLY) and American Capital Agency Corp. (AGNC) have recently cut their dividends. However, two of the components of MORL, Cypress Sharpridge Investments (CYS) and Rait Financial Trust (RAS) raised their dividends during the same period. This slightly mitigated the impact of the larger cuts by NLY and AGNC. July's dividend of $1.1045 was a 16.4% decline from the April dividend of $1.3213. The October dividend is likely to be at least 20% lower than that of July.
I think that the dividends of MORL and Market Vectors Mortgage REIT ETF (MORT), which is the basket of 25 mREITs but without the 2X leverage, can be eventually sustained at somewhat below current levels. There may be one or two more months of declines near the 20% level. For MORL the annualized rate of the last three months' dividends is $5.20, which is a 28.2% simple annualized yield with MORL priced at $18.42. On a monthly compounded basis the effective annualized yield is 32.2%.
In the coming months there should be some beneficial impact from the reinvestment of higher yielding mortgage securities entering the mREITs portfolios. Newly issued mortgage-backed securities usually settle about two months after the purchase date. Each month an mREIT generally receives principal payments on its mortgages of about 3/4 of a percent of the outstanding balance. So newly issue issued mortgage-backed securities bought in June with the receipts of the principal payments, that are yielding about 100 basis points more than earlier this year, are starting to settle and be including the mREITs portfolio.
The questions that must be considered when evaluating the sustainability of an mREIT's dividend are what causes an mREIT to reduce or eliminate its dividend. As investors in non-agency mREITs are all too aware, defaults by the mortgages held by the mREIT can quickly reduce or eliminate dividends. iStar Financial Inc. (SFI), a component of MORT and MORL, has still not reinstated its dividend. Credit issues are not a concern to the extent that an mREIT holds agency paper. Defaults on the underlying mortgages are the problems of the issues such as Federal National Mortgage Association Fannie Mae (FNMA) and Federal Home Loan Mortgage Corp. (FMCC). The mortgage securities of those GSEs (Government sponsored enterprises, the agencies) are still effectively guaranteed by the U.S. Government.
Credit issues played no part in the recent dividend cuts by mREITs. There are other reasons why mREITs cut their dividends. One reason could be because they can. Remember that REITs must distribute at least 90% of their income, as defined in Internal Revenue Service regulations, in the form of dividends to the shareholders. In some cases if there is any way that a REIT can avoid paying dividends, while not incurring a tax penalty, they will do it. A dollar not paid to shareholders in dividends is one more dollar of book value. Many REITs' management fees are a function of book value.
Most REITs today do not want to reduce dividends; rather they know that higher dividends can allow them to do secondary share offerings, which can boost their assets under management and thus their fee income. The mREIT dividend reductions in the past year, except the most recent months, have been entirely due to declining spreads between the interest rates paid on the mREIT's assets and their cost of funds.
Declining long-term rates combined with prepayments of principle on their older higher-yielding mortgage securities have reduced the spread and the incomes of the agency mREITs. They have reduced their dividends accordingly. However, the recent dividend cuts by mREITs were not a result of the spread declining. As I indicated in my article: Federal Reserve Actually Proping up Interest Rates: What this means for mREITs, higher long-term rates while short-term rates remain low actually increases the spread income of agency mREITs.
The recent dividend cuts by mREITs were primarily due to caution or if you prefer fear, on the part of their management. They are conserving cash in order to reduce leverage and possibly use more cash for hedging activities such as buying swaptions. The worst fear for an agency mREIT is that it will not be able to roll-over its repo debt. If my forecast that short-term rates will remain low for much longer, the agency mREITs might gather up their courage and begin to increase their dividends as their spreads and income increase.
If someone thought that over the next five years interest rates would remain relatively stable and thus MORL would continue to yield 32.2% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $403,791 in five years. More interestingly, for those investing for future income the income from the initial $100,000 would increase from the $32,200 initial annual rate to $130,200 annually.