Searching For Yield Amid An Avalanche Of Dividend Cuts

| About: Western Asset (WMC)
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Lately, investors have lost serious capital in mortgage real estate investment trusts (mREITs). What seemed to be good news was the Federal Reserve's "no taper" announcement, which led to a drop in the ten year treasury and gave a quick bounce to the mortgage real estate investment trusts (mREITs). As it turned out that bounce was completely short lived as we learned of dividend cuts in many mREIT holdings, including most I hold positions in. Honestly, there have been some huge cuts, and the yields are suffering in an avalanche of declines.

The largest cut was in my Javelin Mortgage Investment (NYSE:JMI) holding, which led the pack with a huge 35% cut to its monthly dividend. I will address this cut in a later article, but the company now only yields 14%, down from over 20%. The earnings and yield of JMI are still phenomenal, and overall I would suggest you do not panic as the company needs additional cash flow as it continues to adjust to the changing interest rate environment and business climate. Then we learned that both my two favorite mREITs, which are the behemoths in the space, Annaly Capital Management (NYSE:NLY) and American Capital (AGNC) again cut their dividends by 12.5% and 24.0%, respectively, and now yield about 11% and 14%, respectively. When I recently opined on these two cuts, I had thought small cuts were possible and that most of the pain was over. This was especially true given the most recent Q2 report from NLY and the most recent AGNC Q2 report. However, the companies are also still adjusting to the changes. In the grand scheme of things, the cuts hurt short-term, but long-term we should just collect the money (or reinvest the dividend) and let things run. Trust in the management.

After this article was published the usual discussion followed and I received numerous inquiries regarding my other mREIT holdings. Thus, the purpose of this article is to address my fourth largest mREIT, holding Western Asset Mortgage (WMC), which, like its peers, has also seen a large selloff in the last four months. But just how has WMC responded to the madness?

Key Items From The Q2 Report That I Will Be Looking For in Q3.

The most recent WMC earnings report followed the trend second quarter results in the mREIT space. Essentially, it reflected that the company was improving from Q1 and that it was still adapting well to the rise in interest rates. From what I take away from this report, as well as the current dividend, which I will address in a moment, Is that I think Q3 is looking up. I have high hopes for WMC going forward given its slightly different business model from AGNC and NLY. I will be looking for the change in the following Q2 metrics during the Q3 report: First off, WMC reported a Q2 net loss of $27.7 million, or $1.14 per share. The company cannot afford to report many more consecutive losing quarters, and I think Q3 may be a turnaround. I think this is baked into the stock price. In WMC's Q2 loss was $156.3 million of net unrealized loss on RMBS and other securities, $9.6 million of net realized loss on RMBS and other securities (including other loss on RMBS of $2.3 million), and $113.4 million of net gain on derivative instruments and linked transactions. These unrealized losses were high, similar to competitors' reports. In Q2 WMC generated core earnings of $22.8 million, or $0.94 per basic and diluted share. Net interest income for the period was $28.2 million. WMC's weighted average yield on its portfolio was 3.14%, and improvement of 10 basis points over Q1, bucking the trend for most mREITs that were stagnant or saw losses in their yields. I will be looking at the performance of each of these metrics for Q3, but it is important to be aware that WMC's Q1 and Q2 were anomalies given the extreme volatility in interest rates. Thus far in Q3, things have settled down. The key going forward is how will the company reposition itself during this turbulent time and can the company manage to turn a profit? My inclination is yes. I believe this because of the dividend announcement. During Q2 WMC slightly cut its dividend to $0.90 while others were slashing them. Here in Q3, we have seen JMI, AGNC and NLY cut their dividends, 35%, 24% and 12.5%, respectively. But what did WMC do?

WMC Maintains Dividend; Yield Remains Sky High

That's right. While my other holdings are all busy slashing dividends, WMC has maintained its dividend at $0.90. Based on the current price of the stock of $ 17.18 there is a huge draw to WMC in that it currently offers an incredible 20.95% dividend yield. It is now my highest yielding mREIT. It now yields what AGNC historically paid me. The only downside to this announcement was that book value had fallen about 7% to $16.37 as of 8/31/13. But it could have been worse. Into September rates have declined a bit. Book value may have improved. I think the dividend is safe so long as management's transitional plans are executed. This is because the company has a diverse asset mix consisting of residential mortgage backed securities, asset backed securities and commercial mortgage backed securities. Additionally, since the company is moving in the direction of being a hybrid mortgage REIT, it also invests in non-agency RMBS. Further, it will likely be moving into the commercial mortgage business, a trend which many of the residential REITs have been following. Therefore, WMC offers (or will soon offer) potentially complete diversification within the mREIT sector. Now obviously if the company keeps losing money, there will be dividend cuts. We could see a share offer to raise cash, something AGNC and NLY have done numerous times. There is a slight change it could see a further cut to as low as $0.75 in the future if rates stay volatile. However, WMC is positioning to take advantage of a higher rate environment.

How WMC Can Prosper in a Rising Interest Rate Environment

Way back in June I opined that WMC might be able raise its dividend down the road. Obviously this call was incorrect, however, the call was somewhat accurate in that it barely cut its dividend while my other holdings can't seem to cut them fast enough. I will say I broke even on the call. Feel free to call me out on this. The reason I made the call was that despite evidence to the contrary, I thought the WMC dividend was going to be maintained because of its plans to harness and take advantage of rising rates. I took it a step further and suggested it could even rise. I was incorrect, as it was cut slightly to $0.90 in Q2. Here in Q3, it is being maintained at $0.90. I was surprised, but WMC had finances to cover the dividend. I thought they might cut it in order to reposition some of the portfolio and to prepare for a few more turbulent months. In Q1 WMC generated over $52 million in cash from its operations while it paid $27 million in dividends. This left cash flow available to invest in the recent sale in MBS, which I think WMC may be taking advantage of by levering up.

WMC is required to pay 90% of REIT taxable income but this does not necessarily have to be the case quarter to quarter. It has flexibility, provided it meets the 90% threshold annually. What we need to be concerned with is that WMC's taxable income is tied to the change in interest rates. In the prior article I cited WMC's sensitivity analysis showing that if rates go up 50 basis points, WMC would expect to report a 13.9% increase in the coming quarter's net interest income. If rates go up 100 basis points, then WMC estimates an increase in net interest income of 19.0%. Rates are already on the rise and this rise is expected to continue. The only concern would be if short-term interest rates rise too sharply, which WMC notes could reduce income. All things considered, WMC has designed its investment strategy to take advantage of a rising interest rate environment.


The pain has continued in the mREIT sector. My top holdings, NLY, JMI and AGNC, have all slashed their dividends. While we are looking for interest rates to settle down, WMC has taken necessary steps to thrive in a rising interest rate environment. it have chosen to maintain its dividend and continue to yield over 20%. What is critical to the stock going forward is exactly dependent on what management does to reposition during this changing market. If the correct decisions are made and the sensitivity analyses are accurate (and statistically precise), I could see the dividend easily being maintained if not raised again down the road. While 2013 has indeed been an awful year for this young company, it seems to be positioning well for the future. I'm long the stock, most recently adding to my holdings at $16.70. Finally, I will be watching interest rates, MBS values and awaiting the company's Q3 report in early November.

Disclosure: I am long AGNC, JMI, MTGE, NLY, WMC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.