Hatteras Financial (HTS) recently released a new preferred offering. The Series A preferreds yield around 7.6% and are not callable until 2017. Since preferred shares constitute a major portion of my holdings, I decided to take a look at the company. Whenever investors are looking to purchase preferreds, it's best to see how the underlying company is doing in terms of making dividend payments.
When I looked at Hatteras' common stock, I saw the stock had a yield of 12.4%. The stock yields almost 500 bps more than the preferreds. Now this makes sense considering the equity is supposed to have a higher risk premium. Investors need to ask themselves if those 500 bps are worth the extra risk. If we take a look at Hatteras' common stock dividend, we can see that the payment amounts have been declining. The dividend amount peaked on March 2010 at a $1.20. Now the dividend amount is 90 cents per quarter. That's a 25% decrease in two years.
Even though 12.4% is still a fantastic yield, it's very likely that dividend payments could be cut going forward. The reason I wrote this article was because it seems a growing dilemma exists for income investors. Should investors purchase the common shares of these mREITs or should they purchase the preferreds?
Hatteras is not the only mREIT with preferred shares. There are many companies that get their financing through preferred share offerings. Annaly Capital (NLY), Dynex Capital (DX), Resource Capital (RSO), and American Capital (AGNC) have all issued preferreds this year.
Annaly Capital issued its Series C preferred in May. The preferred yields 7.625%. The common stock has a yield of 12.7%. The spread between the two is nearly 500 bps.
Dynex Capital's Series A preferred has a yield of 8.5%. Dynex's common stock yield is 11.1%. The spread between the two is less than 300 bps.
Resource Capital's Series A preferred has a yield of 8.5%. The common shares have a yield of 13.4%. The spread between the two is nearly 500 bps.
American Capital's Series A preferred has a yield of 8%. The common stock has a yield of 14.4%. The spread between the two is more than 600 bps.
So as we can see from the five mREITs mentioned above, the typical bps spread is around 500. When evaluating whether or not the spread is reasonable, we need to understand the many risks that are associated with holding equity compared to preferred stock.
Equities are more susceptible to changes in the overall market. They tend to be much more volatile compared to preferred shares. In addition to this, any slight change in earnings or guidance could increase that volatility.
While volatility is a risk for mREIT common stock, the bigger risk that exists is the dividend payments. The main reason investors buy these mREITs is because of the large yields they carry. However, the issue is that these common shares have had their dividends cut quite a bit.
Annaly's dividend peaked in December 2009 and the payout was 75 cents then. The payout now is 55 cents, which is a 25% decline. Resource Capital has seen its dividend fall by 50% from 41 cents to 20 cents. American Capital's dividend is down 16% from its peak. However, Dynex Capital seems to be the exception from the group. Dynex common stock has seen its dividend payments increase.
So the question income investors need to ask themselves is if the 500 bps spread is worth it, considering it's possible that dividend payments can continue to fall. It's also important to note that a fall in dividend payments would more than likely cause a fall in the stock price.
Personally, I believe the risk might be to great going into the future. However, it is important to note that different mREITs have various different exposures to interest rates. James Shell, an SA contributor, wrote a fantastic article about how certain mREITs would react based on a particular interest rate environment. The article can be found here.
The reason I wanted to write this article was to show that there is a certain risk profile that income investors need in order to buy mREITs. mREIT preferreds are stable and have a fixed rate. The current average spread of 500 bps that exists between the common and preferred yield may simply not be enough for income investors.
Note: The preferreds mentioned above have the following symbols: HTS-A, DX-A, RSO-A, NLY-C, and AGNCP.
Additional disclosure: I am long NLY-C, RSO-A, and AGNCP