ETRACS Monthly Pay 2x Leveraged Mortgage REIT ETN (MORL) declared a monthly dividend of $0.1643 with an ex-date of November 7, 2013 and payable November 20, 2013. This is above the $0.1062 paid in August.
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 "big 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. Thus, the key comparison is with the $0.1062 dividend MORL paid in August. The November payment is an increase of 54.7% from the relevant monthly payment of $0.1062 paid in August. This is the first increase on a relevant month to relevant basis since May. The annualized dividends based on the most recent three-months is $4.19.
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. For the three months ending in October, the annualized rate of the dividends was $3.95. The increase to $4.19 in the three months ending in November was the first such increase since April. The $4.19 is a 2.18% simple annualized yield with MORL priced at $19.20. On a monthly compounded basis, the effective annualized yield is 24.1%.
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 October dividend relative to July 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.
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 having 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. This may have impacted the November dividend. 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.
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 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 (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. Recent poor earnings reported by mREITs such as AGNC and Armour Residential REIT (ARR) suggest further dividend cuts are in store for mREITs in the coming months.
Earlier this year, declining long-term rates combined with prepayments of principal on their older higher-yielding mortgage securities reduced the spread and the incomes of the agency mREITs. They 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.
If someone thought that over the next five years interest rates would remain relatively stable and thus MORL would continue to yield 24.1% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $294,562 in five years. More interestingly, for those investing for future income the income from the initial $100,000 would increase from the $24,200 initial annual rate to $71,284 annually.