"Hope dies last." Russian proverb.
Naturally, mREIT investments are the subject of controversy. mREITs are loved by retail investors who usually hold common shares of such companies in their portfolios, many of them retirement portfolios. American Capital Agency (AGNC), Annaly (NLY), Chimera (CIM), American Capital Mortgage (MTGE) and Hatteras (HTS) are the best known players in the industry. Others point out the fundamental systemic risks they pose due to utilization of large amounts of leverage and speculative trading. The widespread inclusion of mREITs in retail portfolios adds to systemic risk. The biggest myth surrounding the mREIT sector in general is that dividends are thought of as nearly "risk-free" or "arbitrage-like returns" as companies merely borrow large amounts of cheap money, invest it in higher yielding mortgage securities and collect a net interest spread, which is passed on to shareholders in the form of distributions. Prepayment-, duration- and yield curve risk is simply hedged away. mREITs like American Capital Agency and Annaly deliver wildly fluctuating return on equity metrics. In the case of AGNC, the Net loss/Income ROE measure ranges from +50% in Q3 2012 to (34%) in Q2 2013.
Investors need to realize that such ROEs can only be earned with extreme amounts of capital structure risk, which puts dividends at substantial risk, too. Also noteworthy in this result summary is the leverage ratio. As presented, it does not include the full leverage resulting from AGNC's TBA position. The above mentioned line item "Leverage" (4th from above) suggests a declining trend. Buried in the footnotes, however, are the true leverage ratios. Footnote three reads:
Our total average "at risk" leverage, including our net TBA position, was 8.4x, 8.2x and 7.8x for Q2 2013, Q1 2013 and Q4 2012, respectively.
While the ratios are significantly higher, the above mentioned trend suddenly reverses, indicating that AGNC's risk profile has actually increased over the last year. What surely is declining, on the other hand, is the net interest spread, which is a reflection of higher interest rate costs (cost of funds: 1.43% in Q2 2013 vs. 1.13% in Q3 2012). Q2 2013 was apparently a pretty bad quarter for AGNC with great value destruction as reflected in AGNC's book value per share development:
AGNC's dismal Q2 results have markedly contributed to a repricing of mREIT dividend streams. The announced dividend decrease to $0.80 per share represents a 24% sequential decline.
In the chart below, I have compiled all the quarterly dividends from the major companies in the mREIT sector. The table refers to quarterly dividends paid on the common stock without consideration of stubs. The green field in each column represents the highest quarterly distribution on record. In case the highest contribution was held steady, the green cell represents the initiation quarter. The red cells highlight quarters with quarterly dividend decreases. Intuitively, it can be seen that four out of five mREITs posted their highest dividend in 2009 or 2010 (with the exception of American Capital Mortgage). In terms of market capitalization, AGNC and Annaly ($9 billion vs. $11 billion) dominate the sector and can be understood as proxies of the market.
The matrix visualizes when and to what extent dividend cuts were enacted for each individual firm. Annaly's regular dividend cuts are cause for worry: Since 2011 Annaly has decreased the quarterly distribution 8 times (out of a total of 11 quarters). In addition, quarterly dividend cuts are getting larger with an 11% cut in Q2 2013 and a 12.50% cut in Q3 2013. Both American Capital Mortgage and AGNC have decreased their dividends substantially in 2013. What matters more than any individual dividend cut is the big picture with regard to mREIT distributions: Dividends are declining across the board and cuts are accelerating. The recent dismal Q2 sector performance has contributed to a material repricing of mREITs but more capital depreciation is likely since financing costs are almost certain to increase.. Further to consider is the risk of dilution, which every investor faces when investing in mREITs.
The performance summary below gives an enlightening picture of the state of the mREIT sector in general and AGNC in particular. The pick-up in interest rates across all maturities has predictably hit mREITs as evidenced by the scale of dividend cuts. The average unweighted dividend cut from the highest dividend quarter stands at 45% with AGNC achieving a 46.67% cut from its Q4 2009 dividend of $0.75 a share, proving that previously raised doubts about the sustainability of mREIT dividends are justified. The share performance over the last two years shows that the average mREIT lost 21% of its value during this time period. Only Chimera is a positive performer. AGNC took the biggest hit of the peer group with a minus of 34%.
The reversal of expansive monetary policy will further increase funding costs for companies compressing net interest spreads and making the utilization of high leverage unattractive. It is likely that mREITs continue to rely on capital increases to bolster their capital base. In any case, the above depicted dividend development across the sector should indicate that the cycle of dividend decreases is already in full swing. In the case of Annaly, it has already begun in 2009 and no end is in sight. Investors who bought in the last two years are sitting on capital losses that likely exceed their cash flow return. AGNC has continued downside potential as money supply is restricted and investors adjust their lofty dividend expectations. I hold a short position in AGNC with a target price of $11 by 2015.