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In this low interest rate environment, many investors are looking for higher yielding equities to supplement the their fixed income portfolios. One popular option offering dividends that are significantly above average are agency mortgage REITs. Agency mortgage REITs possess very interesting advantages and risks that make them, in many ways, different from most other REITs or equities. Some of their particular risks sparked a sell-off this week, taking most agency mortgage REITs to their yearly lows.

Most REITs are equity REITs that own office buildings, shopping centers, apartment buildings, hospitals and other properties. Mortgage REITs (mREITs), to the contrary, own mortgages on real estate assets rather than the assets themselves. Some mREITs concentrate on commercial property mortgages, while others concentrate on residential property mortgages.

REITs must distribute at least 90% of their taxable income in order to eliminate the need to pay income tax at the corporate level. Under the current tax laws, REIT dividends are taxed as ordinary income, and not at the lower corporate dividend rate. Because these REITs must give away so much income, they cannot grow through retaining and re-deploying earnings. As a result, these REITs often choose to place secondary offerings in order to raise capital and increase market valuation.

Such actions can be either dilutive or accretive to actual share value depending on how productive the REIT is at using the acquired funds; this can also make the quarterly payout volatile. Because these REITs are taxed as ordinary income, many investors appreciate holding them in tax-sheltered accounts, such as an IRA.

Within the world of residential mREITs, there are two primary subdivisions: those that own mortgages insured by federal agencies and those that own mortgages without agency insurance. Agency mREITs are supposed to have portfolios made of mortgages insured by the federal agencies Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC) and/or Ginnie Mae. These government agencies would generally originate or back mortgages and then issue a mortgage backed security (MBS) made up of multiple mortgages to investors. An agency MBS, as opposed to an MBS issued by a non-agency lender, comes with a federal agency guarantee and an implied U.S. government guarantee.

These federal agencies’ implied or quasi-government guarantees have, so far, been proven virtually as solid as any paper issued directly by the Treasury. The U.S. government has thus far bailed out the agencies that have since become effectively bankrupt. As a result, if and when borrowers default on agency-backed loans, the agencies continue to either pay on the borrower’s behalf or buy out the defaulted loan from the owner(s). Buying out loans can have a volatile affect upon the agency REIT's quarterly income, yield and asset valuation, but it is still generally considered a far superior option when compared to an outright default without such a well-funded cosigner.

Below, I have listed six of the largest agency mREITs, in alphabetical order, along with their present dividend yields. I have also included their 5-day, 1-month, 3-month, and 2011-to-date share price performances. These performance numbers relate only to capital appreciation or depreciation, and not to dividends paid. The extent of total return generated from these dividends will differ considerably depending upon factors such as whether they held in taxable accounts, the investors tax rate (as REIT dividends are taxed as ordinary income) and whether dividends are being reinvested.

Annaly Capital Management, Inc. (NYSE:NLY)

    • Yield: 15.23%
    • 5-day: -9.67%
    • 1-month: -9.09%
    • 3-month: -13.24%
    • 2011-to-date: -11.89%

American Capital Agency Corp. (NASDAQ:AGNC)

    • Yield: 21.26%
    • 5-day: -4.36%
    • 1-month: -3.41%
    • 3-month: -11.00%
    • 2011-to-date: -11.82%

Anworth Mortgage Asset Corporation (NYSE:ANH)

    • Yield: 15.52%
    • 5-day: -4.46%
    • 1-month: -4.74%
    • 3-month: -15.61%
    • 2011-to-date: -7.87%

Capstead Mortgage Corp (NYSE:CMO)

    • Yield: 16.10%
    • 5-day: -7.44%
    • 1-month: -10.76%
    • 3-month: -16.67%
    • 2011-to-date: -13.99%

CYS Investments (NYSE:CYS)

    • Yield: 19.34%
    • 5-day: -7.41%
    • 1-month: -9.10%
    • 3-month: -12.00%
    • 2011-to-date: -12.06%

Hatteras Financial Corp (NYSE:HTS)

    • Yield: 16.79%
    • 5-day: -6.96%
    • 1-month: -8.81%
    • 3-month: -17.07%
    • 2011-to-date: -20.78%

Agency mortgage REITs will react to changing interest rates, and they appear to be doing just that. These companies all have far more debt than their market value, due to the leverage they use, and make money off the spread between their borrowing costs and their MBSs’ interest payments. Each company has a proprietary allocation of fixed and adjustable rate securities. Changes in rates will affect the value of these securities and the spreads these REITs can make off of them.

Rising interest rates should largely reduce spreads and portfolio values. While rates have stayed low and trended lower this year, most investors believe rates must eventually rise. Further, it is believed that the current Operation Twist endeavors by the Federal Reserve could have the effect of lowering long-term interest rates while raising short-term interest rates, before both rise together. mREIT spreads are generally based on shorter term interest rates, so this twist could hurt their spreads and leveraged portfolios in the short term.

Recent weakness may also be caused by fear that federal funds normally used for agency MBS financing may be diverted to support European Banks. Such concerns appear to be fueling a steep sell-off in agency mREITs, which are now broadly at or near their yearly lows, with much of their capital depreciation occurring recently. See the 2011-to-date comparison chart, below:

[Click to enlarge]

Washington has not yet developed a reasonable substitute to the current system of backing agency mortgages that, arguably, should have never existed. Government interaction within the mortgage world is unlikely to completely decouple, but a severe reduction or future elimination of agency-backed MBSs would mean the end of agency mREITs. Other potential regulatory changes could include disallowing mREITs to qualify as REITs and/or restricting the leverage multiple that mREITs may implement, though neither such change presently appears highly likely.

Disclaimer: This article is intended to be informative and should not be construed as personalized advice as it does not take into account your specific situation or objectives.

Disclosure: I am long NLY.

Source: Agency mREITs Sell-Off To Start The Third Quarter