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Agency backed mREITs presently offer plenty of dividend yield. Of course, income investors appreciate big dividends. Still, can an investor say the annual yields of the below mentioned mREITs will go on forever? Clearly, the answer is no. For now, however, these names are providing major dividends to investors:

  • American Capital Agency Corp. (NASDAQ:AGNC): Annual Yield: 18.50%
  • Anworth Mortgage Asset Corporation (NYSE:ANH): Annual Yield: 13.90%
  • ARMOUR Residential REIT (NYSE:ARR): Annual Yield: 19.00%
  • Capstead Mortgage Corp. (NYSE:CMO): Annual Yield: 12.50%
  • Hatteras Financial Corp. (NYSE:HTS): Annual Yield: 13.70%
  • Annaly Capital Management (NYSE:NLY): Annual Yield: 13.60%
  • Two Harbors Investment Corp. (NYSE:TWO) Annual Yield: 15.10%

Investors should be aware of the mREIT warning signs, which are clearly spelled out in the SEC filings. Let's make the assumption that nothing lasts forever. The Federal Reserve is utilizing quantitative easing to a significant degree. The Bank of Japan used quantitative easing in the 2001 - 2006 time frame. Investors can step up to the plate, accept the Fed's actions and profit on the status quo. mREITs are the place to be, based upon current U.S. Treasury Bill and Bond rates and yield curve.

Being informed of mREIT risks will put a current mREIT investor at an advantage. The mREIT investor will be one step ahead of the process and will then know when to conclude that mREITs should no longer be held in their stock portfolio. However, for now mREITs make sense. Still, let's prepare for the moment when they aren't the right place to be.

Interest Rate Risk
Let's look at American Capital Agency Corp. (AGNC) and their interest rate risk exposure. Understand that mREITs lever the interest rate spread to enhance profits. This increases AGNC's "net interest income".

Net Interest Income can be defined as the Interest income earned on interest-earning assets (eg. agency backed paper) minus interest expense incurred with interest-bearing liabilities. Click to enlarge:

I extracted the above AGNC interest rate risk from their SEC filings. This chart is on page 43. The change to net interest income can be significant with a -100 basis point swing. AGNC management has provided the mitigated change, reflecting their hedging strategies currently in place.

As the Federal Reserve changes the agency-backed interest rates, the impact to mREITs' net interest income can be significant. The mREIT management teams can reduce the sudden negative change to net income earnings by enacting an effective hedging strategy.

Prepayment Risk
I will examine Two Harbors Investment (TWO) to identify and explain "prepayment risk". TWO was originated out of a special-purpose acquisition company (SPAC). The decision to enter the agency mREIT space has been a fruitful one.

If a borrower repays a mortgage prior to the time anticipated, then the yield can influence the actual bond interest received by the mREIT company versus the expected bond interest received by TWO.

Assume TWO purchases a mREIT at a premium (> $100). A Treasury Bond will trade at a premium if interest rates have declined since the Treasury Bond's origination date. There is an inverse relationship, ceteris paribus, between Treasury Bond interest rates declining and a Treasury Bond's face value going up in value. TWO purchased the bond assuming the yield-to-maturity would be a specific interest rate. If the bond experiences prepayment, then TWO will receive less interest accrued due to the actual-vs-reality shorter time to maturity.

TWO will attempt to mitigate the risk by assuming a certain percentage of prepayments will occur. If this calculation is incorrect, then the actual net income earnings will vary from the expected net income earnings.

Spread Risk
I'll use ARMOUR Residential REIT (ARR) to examine the spread risk. If Federal Government debt securities are trading at wider buy-sell spreads, then ARR is at risk for a margin call on its loans to creditors. This will occur a) if interest rates change rapidly or b) ARR's pledged securities in repurchase agreements swing in valuation which requires ARR to put up additional collateral. In this scenario, ARR may not be able to access a borrowing facility to obtain adequate collateral to submit to the counterparty.

This spread risk is similar to a retail investor who has pledged common stock as margin to purchase other securities. If the pledged common stock declines in value, the brokerage house (e.g., or will demand additional collateral. If the client can not provide collateral within the specified time period, then or will liquidate the common stock holding to fulfill the outstanding loan to client. The retail brokerage unit does not want to be exposed to further losses by the borrower's inability to satisfy the margin requirement.

On ARR's 10Q SEC filing, page 19, the investor can review ARR's repurchase agreement counterparties.

Liquidity Risk
Let's take a look at Annaly Capital Management (NLY), who has been a public mREIT stock for the longest duration in this sector. Michael A. J. Farrell, NLY CEO, is the godfather of the mREIT industry.

I have extracted a SEC NLY (see page 34) table (click to enlarge) to illustrate the liquidity risk. I have, for the purposes of this discussion, removed the full repurchase agreement time frames.

NLY, in a liquidity crisis, may have difficulty turning non-cash assets into cash. NLY has cash and unused borrowing capacity to operate on a day-to-day environment. If NLY assets (e.g., Treasury Bonds, Treasury Bills, derivatives, cash) decrease in value, NLY may be unable - in a liquidity crisis - to provide additional collateral to counterparties.

NLY establishes repurchase agreements with its counterparties. The counterparties are lenders who require specific collateral for respective repurchase agreements. Problems ensue when a mREIT can not meet the demands of its counterparties. NLY has been operating under a 6.3x - 6.7x leverage rate, so problems can become magnified if industry liquidity problems arise.

Extension Risk
Hatteras Financial Corp (HTS) will be used to examine the extension risk within the mREIT sector. HTS, as of March 31st, has a book value of $26.11. The book value can take a hit downward if HTS's management projects its prepayments incorrectly. A lack of prepayments will occur if agency paper interest rates go up faster than anticipated or expected. Borrowers will not repay debt holdings if their current interest rate terms are lower than what the market permits in refinancing. HTS's hedging strategy will be inadequate if their swaps and derivatives are based upon inaccurate prepayment rates. The counterparties have hedges in place and collateral requirements based upon HTS's current asset and liability equation.

Each Company Speaks for Itself
Investors will take note that each company within the mREIT sphere has various returns and degrees of success.

Anworth Mortgage Asset Corporation (ANH) displays - per the below chart (click to enlarge) - under performance against its peers - based upon a basic rate of return calculation. If one compares ANH to AGNC, for calendar year 2010, then one would assume AGNC's management team is far superior than ANH's management team. The rational for one company's over performance can be based upon a wide variety of reasons. This is not necessarily the case. There are many balls being juggled in the air at any point in time.

Investors need to examine what mREIT hedges, derivatives, counterparty risks, prepayment assumptions, unrecognized gains or losses on the balance sheet, and leverage levels were in place. There are a number of balls in the air, and numerous factors need to be analyzed in aggregate to arrive at any reasonable calculation.

Capstead Mortgage Corporation (CMO) has a seven-times total annualized rate of return over the pre-mentioned ANH. ANH has a 3.1% 5-year return vs. the .7% SP500 return over the same time frame. How can it be that CMO has a 21.9% total annualized rate of return over 5-years? There are numerous factors to consider. The assumption that one company's management is better than another company's management team is inadequate unless adequate due diligence has been performed. We are dealing with U.S. Treasury Bills and Bonds, a diverse array of economic factors, and various perceptions of safe leverage levels.

This mREIT review of potential risks is based upon future expectations. Nothing lasts forever. Let's prepare for the day when agency backed mREITs are no longer the best performing sector. Presently, however, mREITs offer high-yields backed by securities guaranteed by the U.S. government.

Nobody is trying to be a hero in the stock market. Let's be ready for the day when we need to change course and exit out of mREITs. Until that day arrives, acknowledging today that agency-backed mREITs are in the sweet spot of the stock market is - in my opinion - correct and profitable.

Disclosure: I am long AGNC, HTS.

Source: The mREIT Playbook: Lots of Rewards, But Lots of Potential Risks As Well