3 Wicked Reasons To Buy Mortgage REITs Today

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 |  Includes: AGNC, CIM, CYS, HTS, NLY
by: Todd Johnson

The equity markets have told us what stocks are making money. One clear winning group is mortgage real estate investment trusts (mREITs). The agency mREITs, which own 100% guaranteed Government Sponsored Enterprise ((GSE)) securities, have outperformed the stock market. Agency mREIT investors have enjoyed financial gains. These gains are occurring due to the deteriorating economic conditions. On one hand, I find it difficult to see the increasing number of hungry and jobless citizens. On the other hand, I have to earn income. In this article I will highlight 3 reasons why the mREITs are an outperforming sector to invest money in today.

1) Agency mREITs own today’s safest asset

There is a global increase in demand for the U.S. Treasury Bills, U.S. Treasury Bonds, and GSE Mortgage Backed Securities. They all possess an implicit 100% guarantee by the U.S. Federal Government.

The demand, in part, for the U.S. debt is due to the European debt issue. The European Sovereign Debt crisis is an ongoing saga of austerity impacts, unresolved budgetary dilemmas, and a blame game amongst all participants. Once again, there is only one answer. As Barry Ritholtz stated in his article “Take the Loss.” The future depends upon banks, countries, individuals accepting losses. Europe, right now, is kicking the can (i.e., “currency problem”) down the street.

Per the below Sovereign Credit Default Swaps’ chart, U.S. currency remains the lowest risk for traders. China’s swaps jumped up 12.54% yesterday. Italy and Spain remain vital to any positive euro sovereign debt resolution. They are perceived to be too big to fail. Greece appears to be burnt to a crisp.

The U.S. is attracting money due to its perceived low risk and the full backing of the Federal Government. Assets impacted include agency mortgage backed securities.

Hatteras Financial Corp (HTS)

Hatteras is an agency mREIT externally managed by Atlantic Capital Advisors LLC. Hatteras invests in adjustable rate and hybrid adjustable rate single family residential mortgage pass through securities. These agency securities are guaranteed by the U.S. Federal Government. Hatteras borrows money at short-term yield and reinvests the proceeds into longer-duration securities. The net yield spread is levered by approximately 7.9x. The net dividend yield is higher when the longer Treasury Bond rates do not compress and decrease the net yield curve.

Due to the tightening of the net yield curve, Hatteras' dividend did decrease. On September 13, Hatteras announced its 4th quarterly dividend of $0.90. The dividend will be paid on January 20. The ex-dividend date is December 21, 2011. This was a decrease of 10 cents from the 3rd-quarter dividend. Hatteras had gone 6 quarters with a $1.00 or more per share quarterly dividend.

Despite the dividend decline, the stock closed up Wednesday at $26.78. An annualized $3.20 dividend equates to a 11.9% dividend yield. This significantly beats the U.S. Treasury Bond yields. In a deflationary environment, agency mREITs provide high dividend yields. The agency mREITs will possess higher book values per share due to their mortgage securities rising in value as interest rates decrease.

CYS Investments (CYS)

CYS Investments is a specialty finance company focused upon achieving consistent risk adjusted investment income. It does this by borrowing short term and investing in GSE mortgage backed securities. The company used 7.9x leverage as of September 30th, 2011.

CYS Investments provided shareholders a solid dividend due to the investment strategy. The company announced a 50 cent dividend for the 4th quarter.

Annaly Capital Management (NLY)

Annaly is known for Michael Farrell’s oversight. He founded the company and has delivered solid returns for shareholders. Annaly is the largest agency mREIT with a $15.73 billion market cap. The current dividend yield is 14.90% with the stock trading at $16.22. Annaly owns 100% mortgage backed securities backed by the U.S. Federal Government.

Annaly has a suite of services it provides to 3rd party companies. Annaly’s subsidiary, FIDAC, manages the Chimera Investment Corporation (CIM) mortgage backed security portfolio. Chimera owns non agency MBS and agency MBS. Chimera is a hybrid mREIT, which will benefit if the U.S. housing market recovers.

In my opinion, Chimera will continue to under perform the mREIT space. The company owns non agency MBS. The home sale numbers, as of December 13, were revised downward. The National Association of Realtors reported the revision number will be “meaningful” and that the “housing market’s downturn” was deeper than initially reported. This is "shocking" news to hear a major economic number has significant revisions.

2) The U.S. is experiencing deflationary impacts to its economy

The U.S. economy continues to experience declining housing prices. This is, in part, due to the increasing number of unemployed citizens. Many unemployed have simply stopped looking for work. The official unemployment number is very specific about how the Government identifies who is unemployed. Many employees are experiencing pay decreases, decreased number of work hours per week, and higher insurance costs. Benefits are being decreased, which puts financial strain on the working class. The working class must use disposable income to pay costs that were previously corporate benefits.

The deflationary impacts support the demand for the dollar and the Treasury Bond markets. The December 14th Treasury Bond yields highlight the compression in longer duration Treasury Bond yields. This directly impacts agency mREITs. If the longer duration paper yield compresses, then it is likely the agency mREITs’ dividends will decrease too. The 30-year Treasury Bond has dropped 21 basis points from December 1, to December 14. This is a 6.7% decrease in the 30-year in 10 trading days.

I went to the grocery store today, and I can say many items are increasing in value. There are clearly pockets of inflationary impacts. I personally noticed agricultural products, such as raw fruits and vegetables, have increased dramatically in retail price.

As a Joe Sixpack investor, I know the increasing costs of living day to day. Costs that continue to go up include healthcare, insurance and groceries. These are basic living costs to society. I am not sure I have experienced buying anything at a reduced price. Home owners, with a mortgage, can refinance at a more attractive interest rate.

3) The Federal Reserve is expected to enact Quantitative Easing 3

A report on November 28, stated 16 of 21 primary dealers believe the Federal Reserve will buy back $545 billion of mortgage backed securities. This action would contribute to a rise in Treasury Bond prices and a decrease in Treasury Bond yields.

Gary Kain recently provided an update on American Capital Agency (AGNC) and its MBS portfolio. Mr. Kain focused upon the prepayment risks, policy risks, and interest rate risk. I believe American Capital Agency is the number one agency mREIT to buy. This is because the company’s focus and discussion is initially centered on risks. Once it has risks identified, hopefully the returns will follow.

On December 1, Mr. Kain gave a presentation at the JP Morgan Small Mid Cap Conference - New York, New York. The presentation dove tailed upon what Mr. Kain has been telling shareholders all along. The company’s main focus is upon maintenance of book value per share.

Mr. Kain, in the presentation, highlighted the expectation of a Quantitative Easing 3 program. This time it would likely have an effect on mortgage backed securities. The company is prepared with the portfolio built to withstand the known and anticipated sector risks.

Action

I personally believe investors must over weight their portfolios with the best agency mREITs. My personal bias is to judge the best mREIT by its current performance, track record, and management.

American Capital Agency has the best performance for the past four years with a 24% total annualized rate of return. Chimera has a negative return of -29.7% over the past 4 years. The numbers assume dividends are not reinvested.

I recommend avoiding Chimera and buying American Capital Agency, CYS Investments, Hatteras, and Annaly.

Disclosure: I am long AGNC, HTS, CYS, NLY.