REITs in general provide an exceptionally handsome value proposition for investors with their durable dividends as well as robust growth. Investing in REITs comes with a few caveats though, as the recent REIT sell-off clearly demonstrates. By mid-May, it had become increasingly clear that the REIT market had pushed prices into the stratosphere, and a market correction was in the offing. Perhaps you are one of the thousands of REIT investors who recently got burned, or, as legendary investor Warren Buffett might have put it, ''left swimming naked when the tide went out.''
Interest rates shot through the roof
A peep through available volatility data such as the CBOE Interest Rate Swap Volatility Index tells you that there was a dramatic increase in interest rates due to a huge increase of 90 bps in mortgage rates while 10-year swaps and Treasury moved by just 75 bps and 90 bps, respectively. This damaged interest income for mREITs. Interestingly, mREITs with a pretty decent hedging program such as American Capital Agency, Inc. (AGNC) were not spared either.
Firm's cash position good enough
American Capital Agency earned $545 million in interest income in the second-quarter, with hefty $5 billion principal paydowns in the ballpark. AGNC also declared its third-quarter dividend of $0.80 per common share on Sept. 19, 2013. Assuming the firm's reinvestments yield rises by 100 bps this quarter, we are likely to see American Capital Agency earn in the region of $565 million. Although this represents an increase over the second quarter, the increase is dwarfed by the $600 million decline in equity recorded during the quarter, illustrating that the net effect of portfolio rollover is helpful but rather limited. Trust the markets to throw you a curveball or a pleasant surprise when you least expect it. The Fed did not begin its QE taper and mREITs such as American Capital Agency celebrated. Judging by its third quarter dividend and it is likely to record $375 million in net income. The good news though is that American Capital Agency's strong cash position means that the firm can withstand a further modest book value erosion without having to sell its investments in a bid to lock-in losses and cover its repo margin calls.
Dividend cut - implications
American Capital Agency Corp. recently announced its third-quarter dividend of just $0.80 per common share, representing a massive 24% cut compared to the previous quarter's dividend of $1.05. There is no denying that the dividend cut was enormous, and it certainly looks even worse when you consider that the firm had slashed another 16% off its first-quarter dividend of $1.25 per common share. In short, this mREIT has shed a massive $0.45 dividend per common share in a short span of just two quarters. So what are we looking at here - should investorsthe expect this ugly downtrend to continue? What are the chances that this scenario will be repeated in coming quarter(s)?
Current dividend now commensurate with American Capital Agency's earning power
I would now like to point out that ugly as the dividend cut looked, American Capital Agency's investors can now heave a sigh of relief. American Capital Agency's current dividend of $0.80 is around the firm's steady-state dividend i.e. a dividend level that the firm can sustain with a modest increase in interest rates. The current dividend yield stands at 13.5% compared to second-quarter's 18.9% yield. This lower dividend yield is more commensurate with the firm's current earning power.
Sufficient UTI left in kitty to cover fourth-quarter
American Capital Agency reported that it had repurchased 11.9 million shares of the firm in the open market during the third-quarter, at an average $22.16 per share (including $263 million expenses). After the dividend payout and the share buyback, the firm will be left with about $317 million UTI (Undistributed Taxable Income) in its kitty, equivalent to $0.82 per common share for the rest of 2013.
In reality, American Capital Agency had enough UTI in its kitty to pay out third-quarter dividends at the previous quarter's level of $1.05. But doing this is, of course, not a very prudent risk management practice since it would only leave about $200 million UTI to cover the fourth quarter. The firm's management, therefore, did the right thing by protecting long-term investors from any further shocks in the coming quarters, at least as far as dividend payouts are concerned.
Other mREITs cut dividends too
American Capital Agency was not alone in the cuts. Annaly Capital Management, Inc. (NLY) slashed its dividends by 12.5% to $0.35 per common share while American Capital Agency non-agency cousin American Capital Mortgage (MTGE) cut its payout by 12.5% to $0.70 per share. Armour Residential REIT (ARR), is a mortgage agency REIT that operates on monthly dividend payouts and announces its dividends prospectively. The firm announced a $0.05 monthly dividend for the fourth-quarter, translating to a 14.7% dividend yield. Armour Residential's third quarter dividend stood at $0.07 per month, meaning that the fourth quarter dividend will be a huge 28.6% drop from third quarter dividends. The firm was among the first agency REITs to expand its purview by going beyond its traditional business of dealing in agency-backed securities. Armour Residential set the stage for a shift in the second-quarter to allow for non-agency purchases. Annaly also responded by adding securities that are backed by commercial mortgages. American Capital Agency's CIO Gary Kain, however, did not make any drastic investment restructuring, preferring instead to stay true to its name and stick to agency-backed bonds. In any case, the firm's sister company, American Capital Mortgage, operates a broader scope, so there really was little need for the firm to change its ballgame.
I had earlier written an article that compared American Capital Agency and Annaly Capital Management where I expressed my concerns that if American Capital's dividend cuts continued at the mid-teen percentage levels or worse, it would not be long before the trend started impugning on the firm's solid reputation as a leading all-weather dividend play. It's sad to see that this has already begun to happen. American Capital Agency's dividend yield of 13.5% in the third quarter is pretty pedestrian, and lags that of Armour Residential (14.7%) and American Capital Mortgage (13.6%). Although American Capital still leads Annaly (11.7% dividend yield), its dividend deterioration is almost twice as large (24% vs. 12.5%).
Summers withdrawal rally fading
The withdrawal by Larry Summers as a Fed chairman candidate had led to a rally, leading to mREITs opening 0.7 % higher on the news. The rally was, however, ephemeral and leading mREITs have reversed the gains, led by Annaly Capital Management, Inc. which has fallen 0.5% since then, while American Capital Agency has lost 0.3%. Annaly is one of the most-respected mREITs and a major competitor of American Capital. Although the firm's dividend yield of 13.7% trails American Capital Agency's 18.9% dividend yield, the firm has a better growth in interest rate spread, which is good for capital appreciation.
Sandler O' Neil does not share the optimism about American Capital Agency and recently downgraded it from a Hold to a Sell with a price target of $21, down from $25. Another pure-agency player Armour Residential REIT, Inc. was also downgraded by the firm to a Sell and the price target lowered to $3.50 from $4.50. Another analyst Compass Point was, however, more sanguine and upgraded Armour to a Buy.
Interest rates are likely to rise gradually from here and this will ease the pressure on American Capital Agency's MBS portfolio. Its hedging strategy that involves holding more 15-year MBS while selling 30-year holdings is likely to be more successful this quarter. Based on these evaluations, a $25 price target still looks realistic to me and it would be wise to hold the stock.