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The mortgage real estate investment trust (mREIT) sector thrives with the current dividend yields. The industry continues to experience political and sector changes. Some mREITs are clearly outperforming their peers. This article will focus upon mREITs to hold, buy, or avoid.

Agency mREITs make money by borrowing funds at short term yield curves and investing in higher yielding government sponsored entity (GSE) mortgage backed securities (MBS).

Most agency mREITs leverage this net yield spread by 6x to 8x. The mortgage securities serve as collateral in order to leverage. The mREITs are extended leverage from a Primary Dealer. GSE securities are guaranteed by the federal government.

Global Landscape

The global economy is weak. European countries are struggling to manage government expenditures versus government revenues. The chart below directly impacts mREITs. If foreign currencies are perceived to be at risk, there will be a flight to safety. The U.S. Treasury Bill and U.S. Treasury Bond market has been a key landing spot for currency safety. The Sovereign Credit Default Swaps highlight, as of December 9th, what countries’ debt obligations are perceived to be at risk:

Key Countries to Watch

In Europe, Germany is the strength of the Euro sovereign debt crisis. Germany’s economy is strong. I equate Germany to being the one eyed man in the village of the blind. Germany, however, does not want - nor can the country afford - to bail out the entire Euro currency crisis.

France, Italy, and Spain are the three other countries I pay close attention to. As any bond, stock, currency investor knows: one must “take the loss”. Debt does not go away. Postponing the end result does nothing but waste time and deteriorates the situation.

Net Yield Curve Impact Upon Agency mREIT Dividends

The mREITs net yield curve will remain constricted as foreign money buys the U.S. Treasury Bills, U.S. Treasury Bonds, and agency mortgage debt obligations. The 30 year U.S. Treasury Bond yields 3.10%. Investors would prefer to earn 3.1% than potentially incur European currency losses.

Hedge for Decrease in Interest Rates

Typically a mREIT must have hedges in place for both rising and decreasing interest rates. One benefit agency mREITs possess right now is mitigated expense to hedge decreasing interest rates. The Federal Reserve can not significantly, from present levels, decrease interest rates. Thus, CYS Investments (NYSE:CYS) has a decreased hedging expense for a decreasing interest rate environment.

The Federal Reserve can only decrease interest rates to zero percent. If the Euro currency crisis does not resolve itself, foreign investors will accept a negative interest rate on U.S. Treasury securities. The demand for U.S. Treasuries could force Treasury Bills to offer a negative yield. Investors know the U.S. Federal Government guarantees the Treasury bills. Investors want the return of their capital. This desire trumps the need for return on capital.

CYS Investments: Buy at Discount to Book Value per Share

CYS Investments did announce good news on December 8th. Stock holders of record on December 19, 2011 will receive a 50 cent dividend for the 4th quarter of 2011. Investors took this news with a glide in their stride. The stock acted well and is trading at $13.33. The 3rd quarter book value per share is $12.35. The current 7.9% premium to book value is over valued in my opinion. On the other hand, the 4th quarter book value per share may increase. A $2.00 annual dividend does provide a 15% annual yield.

American Capital Agency (NASDAQ:AGNC): Buy at Discount to Book Value per Share

American Capital Agency, per the above chart, has earned a 24.1% total annualized rate of return over 4 years. This assumes dividends are not reinvested. The current dividend yield is 19.4%. This yield could compress if the net yield spread decreases. If Treasury Bonds' yields decrease from present levels, then American Capital Agency's net yield spread decreases. American Capital Agency has a short term repurchase (REPO) agreement interest rate in order to borrow funds. The repo agreement rates have remained fairly consistent.

Hatteras Financial: Buy

Hatteras Financial (HTS) is an externally managed mREIT. The stock has run up in the past month. The stock is currently trading at a 2% premium over net asset value. I would recommend waiting to purchase after Hatteras Financial’s 4th quarter goes ex-dividend. The dividend chasers are moving this stock price up. Accumulate when the stock is trading at a discount to net asset value.

Capstead Mortgage: Buy

Capstead Mortgage (CMO) has a unique twist to its role as an agency mREIT. Capstead invests primarily in residential adjustable rate mortgages. The company is a tried and true company. Their business began in 1985. The stock is currently trading at a discount to the 3rd quarter book value and offers a 14% annual dividend yield. I believe this mREIT can be bought at current levels.

mREIT Hedging Expenses

All mREITs hedge their portfolios. Excellent management teams can effectively hedge portfolios to ensure significant book value per share losses are not incurred due to unforeseen circumstances. Annaly Capital Management (NLY), as a publicly traded mREIT, owns the largest agency MBS portfolio. The seasoned management team must hedge their net MBS exposure for prepayment risk, and interest rate risk. Michael Farrell, and his team, have managed risk on an effective basis in all types of markets. Annaly is a proven winner in the agency mREIT sector.

An Ineffective Hedging Strategy

I hope anybody reading this article does not own Invesco Mortgage Capital (IVR). I have previously expressed my opinion why this security should be avoided or sold. I do not claim any special knowledge. The facts speak for themselves. Invesco Mortgage has proven to consistently lose shareholders' money. This is not a personal attack. Invesco Mortgage is only a stock. If our collective goal is to make money, then we should avoid stocks who lose investors' money. This is my common sense understanding of investing.

Invesco Mortgage Capital: Avoid

Invesco Mortgage Capital, on December 8th, announced a 65 cent dividend for shareholders of record on December 22, 2011. This dividend represents a 19% decline from the third quarter payout of 80 cents. I would encourage Invesco Mortgage Capital shareholders to truly look in the mirror and ask yourselves why one owns this mREIT.

To be blunt and brutally honest, Invesco Mortgage is a financial embarrassment within the mREIT sector. This sector is not like a Pepsi (NYSE:PEP) share price declining 10% due to a bad earnings announcement. The mREIT sector is clear in terms of what they own, how to hedge, and performance expectations. Invesco has failed to prove they are a worthy participant in this sector. The stock dropped 6.54% following the negative dividend news.

Anworth Mortgage: Buy

Anworth Mortgage Asset Corporation (NYSE:ANH) is not often mentioned with the big mREIT players like Annaly. Anworth's market is $869 million. The company is currently trading at a 6% discount to net asset value. The company has a stock buyback plan in place due to this discount. The company owns assets which are 100% guaranteed by the U.S. Federal Government. In essence, an agency mREIT is a levered bond fund. The opportunity to pick up Anworth at a 6% discount is compelling. The stock has increased in price in recent days. A 14% annual dividend yield is worthy of investor consideration.

Summary

I focus upon buying the mREITs with a clear understanding of the risks versus rewards. History has indicated that strong management teams continue to outperform. This is transparent in the mREIT sector.

The Home Affordable Refinance Program (HARP) still doesn’t provide any significant threat to the best mREITs, such as American Capital. Gary Kain has actively taken a role to prevent prepayment risk. Top managements are thinking 2-3 steps in advance to preserve their equity’s book value per share.

Edward J. DeMarco, the Acting Director of Federal Housing Finance Agency (FHHA), made the following excerpt in his November 15th speech to the U.S. Senate Committee on Banking, Housing, and Urban Affairs (page 5):

The FHHA is seeking to spread the Federal Government’s agency mortgage backed securities outside the Government. This would result in a significant growth in private label mortgage securities.

I strongly recommend buying mREITs at a discount to book value per share. As the 4th quarter dividend news is hitting the wires, many mREITs are being gobbled up by dividend chasers. The opportunity, hopefully, will arrive to pick up these shares at a lower price once the ex-dividend dates pass.

Source: 6 mREITs To Buy And 1 To Avoid For 2012