Self Directed Investor's  Instablog

Back on June 28 of this year, I suggested to readers here that they may want to look more closely at high yielding agency mortgage backed real estate investment trusts (AmREITs).  I pointed out in the article that as a group, a divergence between AmREITs and the S&P 500 index ETF (SPY) had developed during the previous two weeks.

The grey vertical line just before July 9 on the chart below is the point in time when I asked the question, “Are high yielding AmREITs ready to run?”  Looking back, it is now clear that this divergence was sustainable and AmREITs were indeed “ready to run.” 

 
Source: ValueForum

Let’s look at how the six companies in the AmREIT group have done. Since the closing price on the day after the article was published (June 29), the SPY has gained 15.5 percent. The table below shows that American Capital Agency (AGNC), Annaly Capital Management (NLY), Anworth Mortgage Asset (ANH), Capstead Mortgage (CMO), Hatteras Financial (HTS), and MFA Financial (MFA) have all outperformed the SPY, some spectacularly. The leading gainer in the group, American Capital Agency with a 34 percent total gain, followed closely by Annaly Capital Management with a 30 percent total gain. Annaly also happens to be the largest in the group by market capitalization and the most liquid.

Note:  The total return with dividend reinvestment plan (DRIP) column includes actual dividend payments distributed between June 29, 2009 and September 22, 2009.  Estimated annualized yield includes likely non-recurring dividend payments for AGNC.

 
Source: ValueForum

In fact, an even larger divergence developed between the AmREIT group and the SPY as five of the six companies hit 52-week highs yesterday. The sixth, Hatteras Financial missed a new high by 5 cents. The AmREIT group gained an average of 3.3 percent yesterday compared to the SPY which gained about 0.6 percent. Driving these gains were several bullish dividend declarations. On Monday, Annaly Capital declared a quarterly dividend of $0.69 per share. Yesterday, Hatteras Financial announced a $1.15 per share quarterly dividend and American Capital Agency Corp. declared a $1.40 quarterly dividend payment. The following chart shows yesterday’s closing price, performance, and share volume for each of the six companies in the group.

  Source: Self Directed Investor

Dividend hungry investors will take note that the estimated annualized yields for this group of AmREITs range from 10 to 20 percent. Healthy distribution of dividends seem likely to continue as the Federal Reserve appears to be in no hurry to raise short-term rates amid a bottoming economy and forecast for a jobless recovery. Remember, AmREITs take advantage of the spread inherent in the yield curve, borrowing short term at low-cost while investing in high-yielding, longer term mortgage securities issued by Fannie Mae, Freddie Mac and other government sponsored enterprises.  The greatest risk is if the yield curve flattens as the economy recovers and the Federal Reserve decides to raise the Fed Funds rate.  Funding risk, related to systemic risk, is also a possibility if the short term credit markets fail.

The question now is whether recent divergence between AmREITs and the SPY signal even higher future returns for AmREIT shareholders. As long as the Federal Reserve remains reluctant to raise the Fed Funds and Discount rates, AmREITs look like a very good bet. But remember, even if the Federal Reserve does raise short-term rates, it may not put an end to AmREIT oversized returns. If long-term interest rates are rising along with short-term rates, a favorable spread can be preserved for the group.  The key to an exit strategy in AmREITs is to keep an eye on the yield curve and its spread.

AmREITs  are currently in a very favorable steep yield curve environment that could last for at least another year. Moreover, valuations are not high by historical standards.  AmREITs are a great option for income investors who are willing to manage the risk of a flattening yield curve and able to tolerate  unlikely “funding risk.”  

I recommend—again—that readers look more closely at AmREITs to see if they might fit into your portfolio.

Full Disclosure: Long AGNC, NLY, ANH, CMO.

Agency mortgage backed real estate investment trusts, or aMREITs, are an often overlooked sub-industry in the MREIT industry and are showing recent divergence from the S&P 500.  There is good reason for this divergence given recent economic news on the underlying weak fundamentals of the U.S. economy and the underlying fundamentals in aMREITs.

What are aMREITs?

Many self directed investors do not understand aMREITs. Investors avoid aMREITs either because they are perceived as: (a) “risky” REITs, or (b) deal with even “riskier” mortgage backed securities, or (c) both. These perceptions of risk are wrong and here is why.

aMREITs  are characterized by the following key traits:

1.     aMREITs are not lenders and do not hold individual mortgages;

2.     aMREITs are generally high yielding securities currently ranging from 13 to 25 percent non-qualified annual yield;

3.     aMREITs invest solely or primarily in low-risk agency paper (Fannie Mae, Freddie Mac, VA, FHA) backed by the U.S. government;

4.     aMREITs take advantage of the upward sloping shape of the yield curve, borrowing on a low-cost short term basis and investing in high-yielding, long term securities and generally have a net interest margin of 2 to 4 percentage points.

5.     aMREITs borrow to apply leverage (4x to 10x) to the net interest margin to produce earnings and dividends.

6.     aMREITs are organized as REITs and under U.S. tax law, they must pay out more than 90 percent of their earnings to retain REIT tax advantages.

7.     aMREIT secondary offerings are generally accretive, not dilutive, as companies opportunistically take advantage of wider net interest margins and higher leverage.

aMREITs are a sub-group of the MREIT industry that eliminate credit risk by investing in U.S. government backed securities issued by Fannie Mae, Freddie Mac, and others. Eliminating credit risk is a good thing.

aMREITs generally pay in excess of a 10 percent non-qualified dividend.  High yield is a good thing.

So, what are the risks?

One risk is that the yield curve will become less steep once the economy recovers and the Federal Reserve begins to raise the Fed Funds rate.  This would reduce the net interest margin.

Funding risk—especially for highly leveraged aMREITs—is also a possibility via a failure in the short term borrowing market.

aMREITs Pay High Dividends

There are six companies I follow in the aMREIT sub-industry. They are American Capital Agency (AGNC), Annaly Capital Management (NLY), Anworth Mortgage Asset (ANH), Capstead Mortgage (CMO), Hatteras Financial (HTS), and MFA Financial (MFA).  

Each company is managed a little differently from the others. For example, each has a slight variation on the general theme of investing in low-risk, long term securities. As a case in point, ANH invests largely in securities characterized by adjustable rate mortgages and is subject to re-financing risk when initial rates begin to adjust. On the other hand, AGNC invests in longer term fixed rate mortgages and could be disadvantaged in a rising long bond environment.

As a first start at due diligence, the following table provides current yield metrics based on most recently quarterly dividend announcements and ranked by market capitalization for six aMREITs as of mid-day June 26, 2009.

Source: Self Directed Investor, Inc.

The table is useful as a first look at comparing these companies. But it can be misleading for several reasons. For example, the quality of earnings and therefore future dividend yield differ by company. Another disconnect in the comparison table above is that ANH and MFA haven’t declared their second quarter dividends. The other companies recently declared second quarter dividends.

Divergence from S&P 500 Benchmark

A divergence between aMREITs and the S&P 500 index ETF (SPY) has developed over the past couple of weeks as illustrated by the chart below. The green line represents the six aMREITs listed above purchased in equal weights. The pink line is the SPY.

This divergence may just be noise.

On the other hand, recent bad economic news may be drawing new money into the aMREIT sector. A weakened economy makes it less likely that the Fed will raise the Fed Funds rate.  As a result, investors likely perceive the current upward sloping yield curve as enduring for some time. To borrow a popular term, if the “green shoots” are turning into “brown stalks,” aMREITs are likely to continue paying high yields.  In fact, many aMREITs are underleveraged compared to past economic cycles and could take advantage of a weak economy by increasing leverage.

Self directed investors willing to manage the risk of a flattening yield curve and able to tolerate “funding risk” may want to look more closely at aMREITs. If the economy remains weak, I don’t expect these relatively low valuations to last much longer.

Full Disclosure: Long AGNC, NLY, ANH, CMO.