Seeking Alpha
Profile| Send Message| ()  

In this investment thesis, we have identified Anworth Mortgage Asset Corporation (ANH) as the one mortgage REIT that is likely to cut its dividend in the coming quarter. However, we separately believe that Capstead Mortgage Corporation (CMO) has the financial muscle to continue its lucrative dividend yield of 10%. Therefore, we recommend investors to go long Capstead Mortgage.

The much-awaited third round of quantitative easing (the QE3) has been announced by the Fed. Under the program, the Fed intends to purchase $40 billion worth of mortgage-backed securities every month, until it feels that the economy does not need the required support. The current Agency MBS coupon spread to the 10-year treasury has declined by 54bps to 6bps - this is a decline of 48bps. This large scale MBS purchasing by the Fed will produce a scarcity of these mortgage-backed securities, thus increasing their prices. Increased prices of mortgage-backed securities will result in lower yields. Therefore, in our opinion, mortgage REITs will have an obvious benefit of getting a boost in the values of the existing holdings within their assets portfolios. However, QE3 will also depress the interest rate spreads that these mortgage REITs earn in order to remain profitable. A depressed interest rate spread will translate into lower shareholder distributions (dividend cuts). Annaly Capital Management (NLY) and TWO Harbors Investment (TWO) have trimmed their dividends for the third quarter of the current year, while MFA Financial (MFA) was forced to cut its shareholder distributions at the end of this year's first quarter. Besides the dividend cuts, these mREITs will face significant acceleration in prepayments, which will result in higher amortization costs.

In the remaining report, we look into the possibility of a dividend cut by two mortgage REITs in the U.S. Both mortgage REITs have higher conditional prepayment rates (CPR). CPR is the best measure to track the percentage of the mortgage-backed securities' maturing. Among the major mortgage REITs, Hatteras Financial (HTS) leads conditional prepayment rates with 25.7%, followed by Anworth Mortgage Asset, Annaly Capital Management (NLY) and Capstead Mortgage Corporation at 22%, 19% and 14.5%, respectively. Hatteras Financial and Annaly Capital Management have already announced quarterly dividend cuts. Therefore, we will look into the possibility of Anworth Mortgage Asset Corporation and Capstead Mortgage Corporation cutting their respective quarterly dividends.

Anworth Mortgage Asset Corporation (ANH)

The stock currently offers an attractive dividend yield of 10.5%, which is well backed by a 16% operating cash flow yield. The company shows sustainability in dividend distribution when analyzed over the past four quarters, as reflected by its average dividend coverage of 1.21 times. On average, the company paid $31.4 million in quarterly dividends over the past four quarters, while it generated, on average, $38 million each quarter through its operations.

The company paid per share quarterly dividend of $0.18 in the second quarter of the current year, while it earned exactly $0.18 at the end of the same quarter. For the second quarter of the current year, the company generated $29.3 million in net interest income and paid $30 million in dividends. In its quarterly filings to the SEC, the company also mentions a 59.5% decrease in the projected net interest income, if the interest rates declined by 100bps. Using the same linear relationship, and assuming that projected net interest income will remain the same for the next quarter, a 50bps decline in interest rates will lead to a 29.7% decline in the projected net interest income. This will result in a net interest income of $20.6 million, hardly sufficient to continue dividend distribution in the coming quarters. Therefore, we believe investors can expect a dividend cut.

Capstead Mortgage Corporation (CMO)

Like Anworth, Capstead offers an equally lucrative dividend yield of 10%, which is also well backed by a 16.2% operating cash flow yield. Over the past four quarters, the company on average paid $43.7 million in quarterly dividends, while it generated $57.7 million through its quarterly operations. On average, the cash dividend coverage ratio comes out to be 1.32 times.

The company paid per share a quarterly dividend of $0.4 in the second quarter of the current year, while it earned exactly $0.4 at the end of the same quarter. For the second quarter of the current year, the company generated $65.9 million in net interest income, and paid $45 million in dividends. In its quarterly filings to the SEC, the company also mentions a $10 million decrease in the projected net interest income if the 10-year treasury rate declines by 100bps. Using the same linear relationship, and assuming that projected net interest income will remain the same for the next quarter, a 50bps decline in interest rates will lead to a $5 million decline in the projected net interest income. This will result in a net interest income of $60.9 million, sufficient to continue dividend distribution in the coming quarters. Therefore, we believe investors can expect dividend distribution to continue going forward.

Source: 1 mREIT To Avoid On Potential Dividend Cut, 1 To Buy For 10% Dividend Yield