What The Fed Meeting Really Means For Your mREIT

Dec.31.13 | About: American Capital (AGNC)

The pain of 2013 will not be forgotten by shareholders of American Capital Agency (NASDAQ:AGNC) or Annaly Capital (NYSE:NLY). Both stocks have been cut almost in half in 2013 and the dividends have been decimated. In this article I will discuss what the change in interest rates means for mREITS and discuss what last week's Fed Open Market Committee (FOMC) means for stocks of this nature. I will then discuss the impact of the two on the need for AGNC and NLY to reposition their portfolios and what it could mean for the two. Full disclosure, I am long both stocks and it pains me to continue to dump bad news onto readers. However, that said, both companies are surviving and will do well going forward. The worst is likely over, but it could be a long few quarters.

The FOMC Meeting And Its Considerations

Now, to the heart of the matter. We recently had the FOMC meeting for December. I have been pretty silent on the issue until now. What was the big takeaway? Well we learned that the Fed decided to reduce purchases of both bonds and mortgage backed securities (MBS). And look what happened? NOTHING. For once AGNC and NLY did not find a way to lose 2% to 3% on news out from the Fed (yay!). In all seriousness, if you are an mREIT investor, you want to know about what the tapering means because MBS prices have been underperforming Treasuries lately, though both haven't been all that great. Much of this is a result of bond fund outflows and hedge fund redemptions. Some of it also had to do with panic repositioning ahead of the FOMC meeting as well. So, the FOMC had their meeting. What did they likely discuss? Probably the monthly jobs report. The Street had set the bar relatively low with a 183 thousand increase in payrolls forecast, along with a 7.2% unemployment rate. To the Fed's pleasant surprise, the economy ended up adding 203,000 jobs and the unemployment rate fell from 7.3% to 7.0%. Finally, the labor force participation rate ticked up, which marks one of the few times that the unemployment rate fell because more people were working and not for the wrong reason, because labor participation fell.

Impact on Interest Rates.

As most of us know, AGNC and NLY were doing incredibly well until the Q1 2013 report. Since then, earnings have suffered, the portfolios have been pressured, the interest rate spreads narrowed and book values have fallen because of interest rate volatility. The rapid ups and downs of rates in 2013 have impacted both company's portfolios. Much of this occurred from May up to mid-September. The plain fact is that AGNC, NLY or any other mREIT cannot handle rapid rises in rates. That said, if long-term rates increase gradually while short-term rates stay stagnant this can widen the interest rate spreads. Recall that AGNC and NLY pretty much borrow money and lend mortgage backed securities. What feeds into their profits? The interest rate that these companies borrow at and the interest rate they lend at. That spread has been pressured, but stabilized a bit in the Q3 report. There is a fear even among those who recently opened positions in AGNC or NLY that the damage is not done yet and Q4 could be a disaster as well. After the Fed announcement, rates climbed up, and actually the ten-year eclipsed 3.0%. This means that although AGNC and NLY have been somewhat defensive of late, they are likely scrambling to reposition further.

Repositioning

The rapid rise in rates that was experienced in the summer of 2013 decreased the value of the MBS holdings dramatically. If management held the positions it would lead to their leverage ratios expanding, increasing exposure and ultimately putting a lot of pressure on management. Thus, they sold and sold hard. They took millions in realized losses during Q2 and Q3. It was a necessary evil. This selling pressure spread further put pressure on existing mortgage backed securities' prices. It took two full quarters to adjust. Management sold so many assets that their leverage ratios decreased quarter over quarter. Further, management maximized their hedging against further rate increases. With the Fed announcement leading to another spike in rates, I think AGNC and NLY are better equipped to handle it. However, I am quite certain they have reduced leverage further to prevent more damage to the portfolio. This could in turn mean there will be more realized losses here in Q4.

Thankfully Zero Interest Rate Policy Remains in Place

The post FOMC meeting press conference saw Ben Bernanke gave some further guidance regarding short-term interest rates. One thing that he did was modify the language of the statement such that we can now expect to see a low Fed funds rate for a period well after the unemployment rate breaches the 6.5% threshold. The importance of this statement cannot be understated. You see, it was this language that got the stock market so excited. Currently there is a near-zero short-term interest rate policy (ZIRP) in place. This is key. Once more, Bernanke also asserted that fiscal policy was a headwind even though government spending as a percentage of GDP is the highest since World War II. That said, Bernanke and the Fed seem that they will keep ZIRP in place even if unemployment gets below the 6.5% target. This means mREITs will still have access to cheap cash, as will banks and other financial institutions, with AGNC and NLY and many other mREITs in a much more stable situation as far as leverage is concerned than they were over the summer.

Data Has Been Somewhat Positive for AGNC and NLY

Recent housing data last week was mostly positive as new home sales rose to an annual pace of 464,000 in November. What's more, October's pace was revised sharply higher to 474,000, up from 354,000. This news was strong. Refinance applications have also decreased, which reduces the risk of prepayments. This is also a positive for AGNC and NLY. This data may have provided a cushion for shares. Pending home sales, the S&P Case Shiller Home Price Index and construction spending will be released this week which could solidify the thesis for buying at current levels. Pending sales are expected to show a sharp improvement. Home prices are expected to continue to show an improving home market, with a 1.0% increase seen for the 20-city home price index. Finally, construction spending should increase. However, mortgage applications continue to disappoint.

Lower Dividends In Store?

Annaly's Dividend Announcement

The most recent dividend announcement by NLY lowers the reward for holding the stock as NLY's dividend will now be $0.30, or $1.20 on an annualized basis. At the current price of $10.05 it yields 11.8%. This $0.30 dividend is payable January 31, 2014, to common shareholders of record on December 31, 2013. The ex-dividend date was December 27, 2013.

American Capital Agency's Dividend

Another cut has dropped the yield further as AGNC declared a cash dividend of $0.65 per share for the fourth quarter 2013. This was a cut of $0.15 from the last payout of $0.80. The dividend is payable on January 28, 2014 to common shareholders of record as of December 31, 2013, with an ex-dividend date that was December 27, 2013. With this cut, the stock pays $2.60 on an annualized basis, and at $19.15 a share drops the yield from 16% down to 13.3%.

Conclusion

With the poor action in Q4 2013 and heading into Q1 2014 with interest rates, it is likely the 4th quarter reports will be rough. Without some stabilization once more, it is likely that the next dividend announcement for each company could be reveal another set of cuts. I think a cut is more likely for AGNC at this point due to its lack of diversification. However, with the ZIRP remaining in place, and despite the announcement of the Fed taper, it seems the risk-reward ratio is extremely favorable for mREITs at this point. While there are other mREITs that are more diversified, under $10.00 and $20.00, both NLY and AGNC are compelling buys.

Disclosure: I am long AGNC, NLY. 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.