ETRACS Monthly Pay 2x Leveraged Mortgage REIT ETN (MORL) declared a monthly dividend of $0.0869 with an ex-date of December 11, 2013 and payable December 23, 2013. This is a sharp decline from the $0.1643 paid in November. Much of the decline in the December dividend was due the timing of dividends of some of the individual components of the portfolio which pulls some of dividends into November at the expense of the December period. However, when the combined November and December dividends of $0.2512 are compared to the total of the September and August dividends of $0.1946, we see that the more recent period is an increase of 29.1% relative to the earlier period.
The October "big month" dividend is not really comparable to the "small month" dividends paid in November and December and September and August. 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. The annualized dividends based on the most recent three-months ending in December is now $4.18 only slightly less than the $4.19 for the three months ending in November.
Now that the quarter ending in December 2013 came in at $4.18, this is a 24.3% simple annualized yield with MORL priced at $17.22. On a monthly compounded basis, the effective annualized yield is 27.21%.
The prospects for the January "big month" dividend are problematic since the two largest components of MORL - Annaly Capital (NLY) and American Capital Agency Corp. (AGNC) - have recently cut their dividends and have talked about further cuts. In conference calls and presentations those another components such as Cypress Sharpridge Investments (CYS) and RAIT Financial Trust (RAS) talked about the advantages or reducing dividends to fund stock buy backs..
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.
As I explained in MORL's Dividend Rises In November - Now Yielding 24.1% On A Compound Basis, the rebalancing effect can also work to increase the dividend if an increase in net asset value causes MORL to increase the amount of mREITs held per share 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.
Eventually, 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 are being included in 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. 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. 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 eventually 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 27.2% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $332,541 in five years. More interestingly, for those investing for future income the income from the initial $100,000 would increase from the $27,200 initial annual rate to $90,451 annually.