MORL's Net Asset Value Rises - Implications For The Dividends


The net asset value of ETRACS Monthly Pay 2x Leveraged Mortgage REIT ETN (NYSEARCA:MORL) rose to $20.33 as of October 23, 2013. This was an increase of 19.6% from the low of $17.00 on August 21, 2013. It was also an increase of 11.2% from the level of $18.28 recorded on August 30, 2013. The increase in net asset value has positive implications for the dividend due to the rebalancing effect inherent in leveraged ETNs and ETFs.

As I explained in: MORL Dividend Drops Again In October, Now Yielding 21.5% On A Monthly Compounded Basis, in addition to the decline in the dividend due to the reduction in the dividends of many of the mREITs, MORL is further impacted by the rebalancing of the portfolio each month to bring the amount of leverage back to 2X. As the value of the mREITs in the portfolio declines, portfolio assets must be sold to maintain the leverage level. This reduces the dividend in addition to any reductions from cuts by the mREITs in the portfolio. This factor is of course a major cause of the reductions in many of the dividends of the mREITs in the portfolio. The individual mREITs have been selling assets to bring their leverage down to their targets and in some cases reducing the leverage beyond that in response to the market volatility.

The rebalancing effect also works to increase the dividend as an increase in net asset value causes MORL to increase the amount of mREITs that the dividend is based on. Thus, if the dividends on all of the underlying mREITs in MORL were to remain the same for a specific month, but the net asset value was 11% higher, the dividend paid by MORL, which is a pass-through with no discretion by management, would also increase by 11%. This effect can also result in an increase in the dividends of individual mREITs that employ leverage. However, the individual mREITs have some discretion both with regard to the amount of dividends and to the degree of leverage employed.

Annaly Capital (NYSE:NLY), American Capital Agency Corp. (NASDAQ:AGNC), Cypress Sharpridge Investments (NYSE:CYS) and ARMOUR Residential REIT Inc. (NYSE:ARR) among other mREITs have all announced that the turmoil in the bond has caused them to reduce their leverage and/or increase the amount of hedges that they employ. This would tend to reduce any beneficial effect on their dividends and earnings from an increase in the values of their mortgage securities holdings that might occur if higher net asset values caused them to increase their securities holdings in order to maintain leverage levels.

MORL declared a monthly dividend of $0.7938 with an ex-date of October 9, 2013 and payable October 21, 2013. This is slightly above the $0.75 I projected based on the quarterly dividend paid by Market Vectors Mortgage REIT ETF (NYSEARCA:MORT), which is the same basket of 25 mREITs as MORL, but without the 2X leverage: MORT's Dividend Surprise Increase - Implications For MORL.

Declare may not be the correct word, since MORL management has no discretion in the matter as the dividends are simply a pass-through of the dividends declared by the mREITs that comprise the portfolio. MORL pays "bid month" and "small month" dividends depending on the calendar. 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. During any three-month period all of the components would have paid their dividends. The "big month" October payment was a decline of 28.13% from "big month" July. July's dividend of $1.1045 was a 16.4% decline from the "big month" April dividend of $1.3213.

The last two "small month" MORL dividends were $0.1062 in August and $0.0884 in September. November will also be a "small month" dividend. I think that the dividends of MORL can be sustained at current levels. There may be one or two more months of declines. For MORL the annualized rate of the last three months' dividends is $3.95, which is a 19.6% simple annualized yield with MORL priced at $20.13. On a monthly compounded basis the effective annualized yield is 21.5%.

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 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 included in the mREITs' portfolio.

The questions that must be considered when evaluating the sustainability of an mREIT's dividend is 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 (OTCQB:FNMA) and Federal Home Loan Mortgage Corp. (OTCQB: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 Propping 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 is correct 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 21.5% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $264,714 in five years. More interestingly, for those investing for future income, the income from the initial $100,000 would increase from the $21,500 initial annual rate to $56,914 annually.

Disclosure: I am long MORL, AGNC, RAS, CYS, ARR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.