As many investors already know, the Federal Reserve enacted its power to implement a third round of quantitative easing on September 13th. The action, better known as QE3, will directly affect many of the Mortgage REITs and the portfolios of investors who have positions within the space. In this article I wanted to determine whether or not QE3 would result in a cautionary tale for investors.
The Effects of Quantitative Easing
If we examine QE1 and QE2 a bit closer, we'll notice that the Federal Reserve's decision to keep rates somewhat low while acquiring long-term bonds has been (and will continue to be) a negative catalyst for the Mortgage REIT sector, and many of the companies within that sector. The Fed's actions have tightened the interest rate spread by lowering long-term rates in such a way that short-term rates were less affected. A hybrid of the first two rounds of QE is present in the Fed's action to implement a third round of quantitative easing, or QE3 for short. As a function of QE3, the Federal Reserve is actively buying agency Mortgage Backed Securities (MBS). What does that means for some of the most well-known Mortgage REITs? It means the government is creating a strong demand for the bonds that Annaly Capital (NLY), Chimera Investment (CIM), American Capital Agency (AGNC), Armour Residential (ARR) and Hatteras Financial (HTS) already own, but the rates of these bonds are under some very intense pressure.
In my opinion, it's not just the rates these of bonds potential shareholders need to worry about, it is also the behavior by which these companies have distributed dividends over the last 24 months that surely comes into play. Over the last 24 months we've seen significant declines in each of these companies' dividend distributions and I strongly believe the sustainability of such dividends is heavily dependent on not only the interest rate spread but the rates at which the government purchases these bonds. The second variable to potential investors should consider is each company's prior performance during the first two round of QE.
It should be noted that the first period of Quantitative Easing (QE1) took place from Nov. 25th 2008 and lasted until March 31st 2010. The second round of Quantitative Easing (QE2) took place from November 3rd 2010 and lasted until June 30th 2011. The latest round of Quantitative Easing (QE3) began on September 13th 2012 and it is up to the Fed to determine how long it will last for. The chart below demonstrates the performance of these five firms in each of the phases of Quantitative Easing.
QE3 - Present
American Capital Agency
The Trading Strategy That Ensues
Many income-driven investors within the Mortgage REIT sector are very dependent on the dividend distributions of these companies. As I've noted in a previous article, Annaly Capital (26.47%), Chimera Investment Corp. (50.00%), American Capital Agency (10.71%), and Armour Residential (16.67%) have all reduced dividend distributions substantially. One company I hadn't referenced was Hatteras Financial, which should also be included in the group as the company has reduced its dividend distribution from $1.00/share to $0.80/share, demonstrating a reduction of 20.00%.
Is there a strategy that income-driven investors can use to take advantage of the current dividend distributions coming from the five companies within the Mortgage REIT sector, I've mentioned? The strategy itself is going to be short-term in scope as the dividends of these companies have been cut at least once in the last 24 months.
As Douglas Ehrman points out in a recent article highlighting Mortgage REIT investment strategies, "here is clearly a significant cushion when you are starting at a double-digit yield, but the potential for contraction is significant. As such, one's investment horizon is a critical element. As a shorter or medium-term investment, there is still good potential within such names as Annaly, Chimera, Armour, American Capital and Hatteras but as a longer-term option, there may be better choices". Therefore, potential investors need to look at things from either a 6-month or 12-month perspective and consider small to medium positions until a sustainable level by which dividends are distributed is achieved.
I'd remain cautious on the Mortgage REIT sector as a whole until investors can get a better grasp of how interest rate spreads, bond rates and the rate by which the Federal Reserve buys back many of these Mortgage Backed Securities. One thing to keep in mind is the fact that although the Fed has no intention of raising rates until 2015, investors could very well see mortgage rates get smaller and smaller and therefore realize a continuation in the number of dividend cuts within the sector.