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It's no secret that mREITs such as American Capital Agency Corp. (NASDAQ:AGNC), Annaly Capital Management, Inc. (NYSE:NLY) and CYS Investments, Inc. (CYS) have gone through a very turbulent trading period this year, with all major players losing a sizable share of market value particularly in the last three months or so. mREITs seemed to be moving in a perfectly elastic inverse correlation to 10-year Treasury yields, which is perfectly understandable. These leveraged investments have also been reacting strongly to other industry developments, such as the news that the Fed did not begin its QE taper on Sept. 18, 2013, as previously expected. CYS Investments led the mortgage agency party, shooting up an industry-leading 3.7%. Elsewhere, American Capital Agency gained 3.5% and Annaly Capital Management rose 3.2%. The mREIT industry as a whole gained 2.8%.

Second-quarter scenario

American Capital Agency cut its third-quarter dividend by a whopping 24%. Annaly, on the other hand, cut its dividend by just 12.5%. Following the recent mREIT developments, investors are now wondering which mREIT offers better investment value between the two behemoths of the space: American Capital Agency and Annaly. Many mREIT investors not only need high-income paying stocks but also those that offer a certain level of protection against loss of capital. When you consider the second-quarter results, Annaly came off as the better mREIT for investors, although not by a wide margin. You can arrive at this conclusion using the following four criteria

  • Dividends
  • Interest Rate Spread
  • Earnings, and
  • Book Value

Dividends

Annaly Capital Management reported a $0.40 dividend per common share for the second-quarter, a 2.25% fall from first-quarter's $0.45 dividend per common share. The dividend was also considerably lower than 2012's second-quarter dividend of $0.55. Although Annaly's dividend for the quarter was quite low, it was well within the firm's estimated taxable income per share of $0.47. This means that the firm had sufficient cash/earnings to pay out the dividend. At a share price of $11.30, the dividend was equivalent to an annualized yield of a respectable 14.0%.

American Capital Agency Corp. reported a second-quarter dividend of $1.05 per share, 16% down from first-quarter dividend of $1.25 per share. Although the firm's dividend fell considerably, it still beat consensus estimate of about $1.00 per share. The $1.05 payment per share was less than the firm's dollar roll income and net spread of $1.15 per share. American Capital therefore had sufficient cash to pay out the dividend. The dividend yield worked out to an annualized top-of-the-line 18.9%, when calculated at a $21.90 share price. This helped to buttress the firm's solid reputation as a leading all-weather mREIT dividend play.

Although American Capital took the cake for a higher absolute dividend yield of 18.9% compared to Annaly's 14.0%, its dividend deterioration outpaced Annaly's at 16 % vs. 11%.

Third-quarter dividends

The two firms have already declared their third-quarter dividends. American Capital Agency declared a $0.80 dividend per common share while Annaly declared a $0.35 dividend per common share. American Capital Agency dividend yield in the third-quarter works out to 13.5% while Annaly's works out to 11.7%. Although American Capital Agency's dividend yield is still considerably better than Annaly's, its dividend deterioration was almost twice as large (24% vs.12.5%).

The good news for American Capital Agency is that its current dividend yield of 13.5% is now more commensurate with the firm's earnings power. I expounded on this quite a bit in a recent article that you can read here. We are, therefore, not likely to see dividend cuts for the firm at this rate in the coming quarters.

Interest rates spread

Interest rates fluctuated wildly in the second-quarter, thus improving the interest rate spread for many mREITs. The cost of borrowing rose at slower pace compared to the pace at which yields from investments rose. Annaly reported a 0.98% net interest spread, an improvement over first-quarter's 0.91%. The interest rates spread was, however, considerably lower than last year's second-quarter spread which came in at 1.54%. The firm's asset yield for its interest-earning portfolio stood at 2.51%. Its average cost of funds shot up seven basis points to 1.53%.

American Capital Management Corp. interest rate spread for the second-quarter came in at 1.86%, a marginal drop compared to first-quarter's 1.87%. If we exclude the firm's TBA dollar roll income, net spread falls to just 1.49%, a slight drop from first-quarter's 1.51%. American Capital Agency's asset yield stood at 2.71% while its average cost of funds shot up 15 basis points to 1.43%.

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 were not spared either.

The average yield on assets rose by a higher absolute amount than the cost to borrow in the second-quarter, leading to improved interest rates spread for both mREITs. Although the spread for both firms was okay, American Capital Agency beats Annaly hands down for a much larger spread. Annaly Capital Management, however, beats American Capital to the tape when we consider interest rate spread growth Q-o-Q. Growth in interest rates spread is more important for capital appreciation than simply larger, but stagnant, absolute spreads.

Earnings

Annaly Capital Management, Inc.'s second-quarter results looked pretty good. The firm returned a GAAP net income of $1.6 billion, equivalent to $1.71 per average common share. This was a huge 83.8% growth over first-quarter's GAAP net income of $870.3 million, or $0.90 per average common share. Annaly second-quarter numbers look even more impressive when you compare them to last year's second-quarter results, when the firm booked a ($91 million) loss, or ($0.10) loss per average common share.

In sharp contrast, American Capital Agency Corp.'s second-quarter results looked pretty ugly. The firm booked a nasty overall loss of ($936 million), or a ($2.37) comprehensive loss per common share.

Earnings are largely dependent on rate spreads, so we shall have to wait for the third-quarter to come to an end before we can analyze and see how the rate spreads for the two firms panned out and how it affected their incomes.

Annaly's second-quarter earnings were quite obviously better than American Capital Agency's.

Interest rates spread

Interest rates fluctuated wildly in the second-quarter, thus improving the interest rate spread for many mREITs. The cost of borrowing rose at slower pace compared to the pace at which yields from investments rose. Annaly reported a 0.98% net interest spread, an improvement over first-quarter's 0.91%. The interest rates spread was, however, considerably lower than last year's second-quarter spread which came in at 1.54%. The firm's asset yield for its interest-earning portfolio stood at 2.51%. Its average cost of funds shot up seven basis points to 1.53%.

American Capital Management Corp. interest rate spread for the second-quarter came in at 1.86%, a marginal drop compared to first-quarter's 1.87%. If we exclude the firm's TBA dollar roll income, net spread falls to just 1.49%, a slight drop from first-quarter's 1.51%. American Capital Agency's asset yield stood at 2.71% while its average cost of funds shot up 15 basis points to 1.43%.

The current mortgage rate stands at 4.5%. We shall have to wait till the third-quarter results come in to get a full picture of the two firm's interest rate spreads.

In the second-quarter though, the average yield on assets rose by a higher absolute amount than the cost to borrow, leading to improved interest rates spread for both mREITs. Although the spread for both firms was okay, American Capital Agency beat Annaly hands down for a much larger spread. Annaly Capital Management, however, beat American Capital to the tape when we consider interest rate spread growth Q-o-Q. Growth in interest rates spread is more important for capital appreciation than simply larger, but stagnant, absolute spreads.

Book value

Annaly's current price is $11.63 against a book value of $13.04. Its price to book value ratio therefore works out to 0.89.

American Capital Agency on the other hand is currently trading at $22.88 against a book value of $25.09. Its price to book value works out to 0.91. Both stocks are therefore trading at a considerable discount to book value. Compared to the REIT universe as covered by the Dividend Channel, the average price to book ratio is 2.1. Both stocks are a great bargain, at least as far as discount to book value is concerned.

Annaly lost 14.2% book value in the quarter, compared to American Capital Agency's 11.4%. This revelation should not come as a surprise to investors, since the firm is less leveraged than American Capital Agency. American Capital Agency has more exposure to TBA which probably weathered the storm better than Annaly's MBS.

Annaly, nonetheless, managed to outperform long-duration ARM REIT Hatteras (NYSE:HTS), whose book value declined by a staggering 20%. In the REIT space, firms with greater exposure to fixed-rate MBS as well as long-duration ARMs were the hardest hit, while REITs with more exposure to non-agency papers such as MFA Financial (NYSE:MFA) and Two Harbors (NYSE:TWO) fared much better. Firms with service exposure, such as Nationsta, performed the best.

The volatility of mortgage-backed securities (MBS) prices has led to both stocks declining considerably in the third quarter. In the current quarter, Annaly has declined 14.2% in book value while American Capital declined 11.4%. American Capital, therefore, lost far less book value and is the clear winner in this category.

CYS Investments favors a more aggressive play
CYS Investments is trading at a 15% discount relative to book value. The company's stock is regarded as being particularly rate-sensitive because of its relatively higher leverage and duration gap. This is the main reason CYS gained the most after the taperless news.

The recent withdrawal of Larry Summers as one of the candidates to replace retiring Fed Chairman Ben Bernanke may have also reduced the chances of a sharp move into higher interest rates. These new developments favor CYS Investments and other mREITs, at least in the short term. CYS may be more likely to respond more vigorously to stable interest rates, however, making the stock well-suited for investors willing to stomach more risk.

The better value for investors

Annaly seemed to outperform American Capital Agency in the second-quarter in various important categories. At this point in time, it might be better to wait till the full third-quarter results are out before deciding between the two mREITs.

Going forward, if Fed choose to taper but does not raise its Fed Fund rate, dividends for mREITs will likely be more robust than what we saw this quarter.

Dividend investors who approach investing purely from a value standpoint are mostly interested in the most profitable companies that also happen to be trading at attractive valuations. Annaly was recently named as a Top 25 dividend stock. Its shares display attractive valuation metrics as well as robust profitability metrics.

Source: American Capital Agency Corp. Dividend Deterioration Worrying