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Yield hunger has been a major theme in the stock market since the low interest rate environment set in two years ago. Investors screening stocks for yield will inevitably turn up names like Annaly Capital (NYSE:NLY), Hatteras Financial (NYSE:HTS), and American Capital Agency (NASDAQ:AGNC). These stocks and some others are sometimes called "agency mortgage REITs." It is very important for yield oriented investors to understand these companies because they present both opportunities and potential risks.

The world of real estate investment trusts (REITs) is generally divided into equity REITS (which own equity in office buildings, shopping centers, apartment buildings or other structures) and mortgage REITS (which own mortgages on real estate assets). Within the universe of mortgage REITS, investors usually distinguish between commercial mortgage REITS, which own mortgages on commercial properties, and residential mortgage REITS which own residential mortgages. Finally, some residential mortgage REITS own mortgages which are not insured by federal agencies, while agency mortgage REITS have portfolios made up largely if not exclusively of mortgages insured by federal agencies (Fannie (OTCQB:FNMA), Freddie (OTCQB:FMCC), and Ginnie). These mortgages are held in the form of mortgage backed securities guaranteed by one of the United States government agencies.

As REITs, these companies are generally not taxed on their income but are required to dividend 90% of that income to shareholders; the income is generally taxed as ordinary income to the shareholder. For this reason, REITs generally cannot expand by retaining earnings and so must periodically engage in secondary offerings. There have recently been a spate of agency mortgage REIT offerings due to the attractiveness of these securities to yield oriented investors. Sometimes these offerings have adverse effects on the price of the stocks. The 90% dividend requirement also means that the dividends of these companies will vary from quarter to quarter based on earnings and that investors will not seem to smooth, inexorable, but slow increase in dividends that a JNJ or KO seems to be able to generate. Often, one of these stocks will take a hit based upon a drop in the quarterly dividend.

Of course, the big advantage is the yield. Based on recent data, stocks in this sector have yields between 12 and 19% and, thus, are candidates for inclusion in IRA and other tax sheltered accounts. I have been able to identify six stocks in this group - after each name and symbol I will provide Monday's closing price, the price/book ratio, the ratio of debt to equity and the latest dividend yield:

  1. Annaly Capital (NLY) (18.03) (1.18) (6.5) (14.3%)
  2. American Capital Agency (AGNC) (29.10) (1.21) (8.8) (18.5%)
  3. Hatteras Financial (HTS) (7.12) (1.14) (5.6) (13%)
  4. Anworth Mortgage Asset (NYSE:ANH) (7.12) (1.04) (6.0) (12.5%)
  5. Capstead Mortgage (NYSE:CMO) (13.40) (1.10) (7.1) (12%)
  6. Cypress Strategy (NYSE:CYS) (12.76) (1.08) (7.4) (19.2%)

Before you read further, relax for a moment and enjoy looking at those yields - like an oasis in the Sahara, these securities promise what is terribly scarce in the current investment environment. Now back to reality. To put this sector in perspective, it is important to realize that the market cap of NLY ($14.5 billion) is roughly twice the combined market cap of the other five companies. NLY, CMO and ANH date back to the previous century; the others have only been in the business the last three years.

This may be important because the business these companies are engaged in has certain risks. On the one hand, the federal agency guarantee provides assurance against losses due to default. Investors should be aware of the fact that the one thing almost everyone in Washington agrees upon is that "something should be done" about Fannie and Freddie.

Unfortunately, or perhaps fortunately for investors in these securities, no one in Washington has articulated any remotely plausible alternative to the current system (I hereby brace myself for the blizzard of negative comments that this remark will engender). For example, mortgages in the United States are really unique in that the interest rate risk is a "one way street"; if rates go down, the homeowner can, without penalty, prepay the mortgage and refinance at a lower rate. If rates go up, the lender is stuck for 30 years with an instrument yielding below the market interest rate.

That's not the way it works in corporate finance - companies have elaborate "subject to call" limitations and premiums in their bonds. And even the federal government simply takes it on the chin and pays high rates for the duration of the bond when market rates go down. There are probably some 30 year treasuries near maturity now that still have double digit interest rates. If we get rid of the currently (subsidized) system of housing finance, a purely private market would demand some combination of shorter maturities, prepayment penalties, and higher interest rates - or, more likely, might not provide long term fixed rate mortgages at all.

And that is really the problem here. Changing interest rates. The agency mortgage REITs must navigate the rapids of changing interest rates very carefully. The only way in which they can produce these high dividend yields is with leverage. They borrow six or 8 times capital and pay lower interest rates on their borrowings than they earn on the mortgage backed agency securities. They make decisions about the mix of fixed and floating rate agency securities they hold, the arrangements on their borrowings and how to hedge against an increase in borrowing costs.

The rate of prepayments of mortgages in a mortgage backed security can affect both the value of the security and the interest yield it produces. Since the fall of 2008, leverage has made me really nervous and it actually kept me away from this sector for a while. I still have some fears about possible changes in federal policy or a panic in which lots of these agency securities are dumped on the market by leveraged entities responding to lender pressure. Unfortunately, these kinds of yields do not come without risks.

Examine a chart of NLY and you will see some of the things that can happen. While NLY has superb management (Michael Farrell is probably the "pinball wizard" of this business), the stock has had some nasty dips - one in late 2005 and another in 2008 (who didn't?). On the other hand, these dips were not nearly as bad as some of the other catastrophes suffered in the financial sector. The point is that just because you are investing in an entity which owns securities guaranteed by an agency of the United States government, it does not follow that you are insulated from risk. There probably is little or no default risk but there is considerable interest rate risk.

To be more precise, the risk is that the current wide spread between the interest rates that these companies pay to lenders and the rates that they earn on agency backed securities narrows. As it narrows, the net interest income of these companies will decline, and the market value of some of the securities may also decline, leading to lender pressure to reduce leverage. This will tend to happen if short rates go up and long rates do not move up proportionately.

I do not see this happening soon but, of course, once the trend becomes clear, an investor has already taken a substantial hit. A big interest rate move of this type could reduce the book value of these stocks and drastically reduce the income stream. And that would likely drive the market price of these stocks down as well. I do not see this happening on a big scale any time soon but an investor in this sector has to keep on eye on the interest rate situation and understand its potential impact.

As noted above, these companies are aware of this risk and take various measures in terms of portfolio composition and borrowing strategy in order to minimize that risk. These strategies vary from company to company and it is beyond the scope of this article to go into them in detail.

As I have indicated with respect to BDCs, the best approach to this sector is to spend some time looking at the individual companies and build a diversified portfolio so that you minimize the risk of picking the one manager who zigged when he should have zagged. I would overweight NLY based on its size and track record. I would not recommend that a dividend investor put all of his apples in this basket. Other mortgage REITS, BDCS, MLPS, and dividend stocks should be included as well.

That said, agency mortgage REITs are an important tool in the dividend investor's kit.

Source: Dividend Investor Boot Camp: ABCs of Agency Mortgage REITs