Positive Performance Follows Most Agency Mortgage REITs' Reporting, Except Annaly

Includes: AGNC, CMO, CYS, HTS, NLY
by: Zvi Bar

Within the last two weeks, most of the large agency mortgage REITs reported their results for the fourth quarter of 2011. The group has acted well since receiving the onslaught of news, including reports from American Capital Agency Corp. (NASDAQ:AGNC), Annaly Capital Management, Inc. (NYSE:NLY) and Hatteras Financial (NYSE:HTS), though the first two reported below expectations, all three noted reduced spreads that are likely to get tighter in the first quarter of 2012.

On Tuesday, February 14, 2012, Hatteras reported results for the fourth quarter and full year for 2011. During Q4 2011, Hatteras earned net income of $70.6 million, or $0.92 per share, compared to net income of $79.0 million, or $1.04 per share during Q3 3011. The results were in line with Wall Street expectations.

Hatteras also reported net interest margin decreased to 1.56% from 1.64% in the prior quarter. Their portfolio's weighted average coupon was 3.46% during Q4 of 2011, compared to 3.54% during Q3. The annualized yield declined to 2.60% in Q4 2011, compared to 2.72% in Q3 2011. Hatteras lowered its dividend last quarter and may do the same this quarter, though it might be able to pay the same 90 cents it paid last time.

On Tuesday, February 7, 2012, Annaly reported net Q4 income of 54 cents per share, compared to 60 cents for the same quarter in 2010 and 65 cents for Q3 of 2011. Wall Street expectations were for earnings to be slightly higher, and on average, between 56 and 57 cents per share. Annaly did not yet report on its forthcoming dividend, but a minor dividend reduction appears probable.

On Monday, February 6, 2012, American Capital Agency reported net Q4 income of $208.7 million, or $0.99 per share, compared to $1.39 per share during Q3 of 2011. Following their announcement of earnings, AGNC also announced a dividend policy cut, lowering the quarterly payout to $1.25 from 1.40 per share. This was the first time in two and half years that AGNC cut or changed its quarterly dividend.

Mortgage REITs own mortgages on real estate, and usually primarily residential mortgage-backed securities insured. These RMBSs come in many forms, but a major differentiating characteristic is whether they are backed by federal agencies. If backed by a federal agency, the RMBS has an implied government backing when the primary borrower defaults.

Agency mortgage REITs should have portfolios exclusively composed of mortgages insured by federal agencies. Such agency paper is fairly close to a U.S. Treasury, though it does have added risks and a slightly higher yield.

The government has opted to continue bailing out agency securities. Additional borrowers continued to default on agency-backed loans last quarter and into this quarter, and the agencies continue to pay on their behalf and often eventually buy out the defaulting mortgage. Prepayment buying-out of loans has a volatile affect on an agency REIT's quarterly income, spread and asset valuation. Nonetheless prepayment is dramatically preferable to an outright default.

Below is a two week comparison chart for the above-mentioned mREITs and two smaller peers, Capstead Mortgage Corp (NYSE:CMO) and Cypress Sharpridge Investments (NYSE:CYS):

Most of these REITs are up over the last two weeks and through this reporting period. An noticeable dip afflicted Annaly after its earnings miss, which can be seen on the chart on Wednesday, February 8, the day after its after hours report release.

Within the last week, all five are up, with the strongest being Hatteras, which met expectations :

Despite the recent reports by agency REITs that were below Wall Street expectations, these REITs are all positive so far in 2012, appreciating between 3.5 and 8.9 percent. The group's average annual yield now stands at 14.26 percent, though some payouts may come down in the coming weeks. Though Annaly did have an immediate move down after reporting, shares have been stable since.

Low borrowing rates should help these REITs, at least in the near term, maintain profitable spreads. Continued low rates should be expected to cause investors to seek out high-yielding income alternatives including REITs. Over the last few years, Federal Reserve comments have generally been positive for agency REITs. Eventually, interest rates will rise and these agency mREITs will have to react.

These agency REITs occupy some of the highest-yielding space in most portfolios, but that yield comes with some risks. The quarterly payout of an agency mREIT usually outperforms the annual payout on a 10-year Treasury or the S&P 500. Most of these agency REITs will report dividend policy in the coming month, with some reductions generally expected.

Exposure to agency REITs should be limited to a reasonable portion of an income oriented portfolio, with the understanding that the dividends are not guaranteed to grow or even be maintained at their current rates in the coming quarters.

Disclosure: I am long NLY. 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.