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As the Federal Reserve has decided to remain accommodative until late 2014, yield focused investors have been attracted to high-dividend paying securities. In a search for yield investors should remain cautious on mortgage REITs due to rising prepayment risks.

Agency mortgage REIT investors should be aware of high conditional prepayment rates. Prepayment rates ended the year near 2011 highs as mortgage rates plummet to historical lows. While the government is intervening in the mortgage market, higher coupon securities remain vulnerable to higher prepayment speeds.

Mortgage REITs including Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) invest in agency mortgage backed securities issued by Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC), and Ginne Mae. Securities from these agencies carry an implicit guarantee backed by the U.S. Government. Due to the lack of inherent credit risk, agency mortgage REIT investors need to focus on interest rate risk and prepayment risk.

Interest Rate Risk

Due a weak economic outlook and stubbornly high unemployment rates, interest rates will likely remain low for quite some time. Any future increases in interest rates will likely be well telegraphed by the Federal Reserve and beyond 2014.

Prepayment Risks

While higher interest rates are unlikely to pose a real risk in the next few years, investors should beware of prepayment speeds. Mortgage REIT investors should focus on conditional prepayment rates (CPR) to monitor the health and dividend potential for mortgage REITs. The CPR reflects the percentage of principal that is prepaid over a period of time on an annualized basis.

As CPRs increase, the company will have to invest in securities with lower coupons, which will hurt earnings. Mortgage REITs are highly levered investment vehicles, which employ significant leverage to generate yields.

According to eMBS prepayment rates have been rising over the last three months. The chart below outlines the increase in prepayment rates for agency mortgage back securities. Investors have been pointing to rising prepayments for rationale as to why certain agency REITs have cut their dividends in the most recent quarter.

(Click chart to expand)

Agency REITs with bias toward Fixed Rate Mix

Annaly Capital Management

American Capital Agency

Agency REITs with bias toward Floating Rate Mix

Anworth Mortgage Asset Corp. (NYSE:ANH)

Capstead Mortgage Corp. (NYSE:CMO)

Hatteras Financial Corp. (NYSE:HTS)

Annaly Capital Management, Inc.

Price to Book: 1.0x

Dividend Yield: 13.8%

Leverage: 5.5x

American Capital Agency

Price to Book: 1.05x

Dividend Yield: 19.9%

Leverage: 7.9x

Anworth Mortgage Asset

Price to Book: 0.92x

Dividend Yield: 13.4%

Leverage: 8.5x

Capstead Mortgage

Price to Book: 1.01x

Dividend Yield: 13.7%

Leverage: 8.2x

Hatteras Financial

Price to Book: 1.02x

Dividend Yield: 13.7%

Leverage: 6.7x

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Be Cautious On Mortgage REITs