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.