Desperately Seeking Yield Through Equities: Part 2 - Agency REITs

by: Philip Mause

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Probably the highest yields that are available in the equity market are the dividend yields on agency mortgage real estate investment trusts (Agency REITs). REITS generally have the characteristics of flow through entities described in Part 1 of this series. 90% of income is generally transferred to the shareholders as dividends and dividends are generally taxed as ordinary income. (Some dividends of equity REITs can be taxed as capital gains or treated as a return of capital.) Because REITs cannot retain much income, there is a tendency to have secondary offerings in order to expand.

REITs generally are divided into equity REITs (which own property) and mortgage REITs (which own mortgages), although there are some REITs that own some equity and some mortgages. Within the mortgage REIT category, there is a generally recognized division between commercial mortgage REITs and residential mortgage REITs. Finally, some residential mortgage REITs own mortgages (or mortgage backed securities) guaranteed by a federal agency [Fannie Mae (OTCQB:FNMA), Freddie Mac (FMCC.OB), or Ginnie Mae] and some own residential mortgages without such guarantees. There are hybrids, which own a variety of mortgages, as well. This Part will concentrate on the Agency REITs, which own mortgages or mortgage backed securities guaranteed by a federal agency.

One might think that he had discovered the best of all possible worlds in Agency REITs. After all, they tend to have the highest dividend yields available in the market and at the same time they invest in some of the safest securities. The secret is attributed to what has become a dirty word in some quarters of late: leverage. Agency REITs own a portfolio of securities roughly 7 to 9 times larger than their capital and finance it with debt (often through repurchase agreements). In a portfolio with 8 to 1 leverage, if the interest rate earned on the securities is 2 per cent higher than the interest rate charged on the debt, the Agency REIT has net interest income of 16 percent of invested capital on the debt financed part of its portfolio. Before getting into more detail, here is a list of Agency REITs, with Tuesday's closing price, current dividend yield based on the most recent dividend or, where applicable, the most recently announced dividend, and leverage(ratio of debt to net assets).

  • Armour Residential (NYSE:ARR) (7.65) (18.7) (9.6)
  • Cypress Sharpridge (NYSE:CYS) (13.15) (18.3) (8)
  • Annaly Capital (NYSE:NLY) (18.39) (13.6) (7)
  • American Capital Agency (NASDAQ:AGNC) (30.39) (18.6) (7.7)
  • Hatteras Financial (NYSE:HTS) (28.89) (13.9) (7.8)
  • Anworth (NYSE:ANH) (7.25) (13.9) (8)
  • Capstead (NYSE:CMO) (13.65) (14) (8.9)

These are truly extraordinary dividend yields in this interest rate environment. Unfortunately, running one of these Agency REITs is not as simple as borrowing some money, buying a bunch of agency mortgage securities, and tallying up the returns each month. There are a number of factors that affect both the value of and the return on a group of these securities and the portfolio must be carefully managed and sometimes hedged against an assortment of risks. Probably the greatest risk is an increase in interest rates. I did a piece comparing the performance of Agency REITs and BDCs during the 2004-06 series of interest rate increases and the Agency REITs did not perform very well. Interest rate increases drive up the cost of borrowing but do not generate higher interest rates from the agency backed mortgage securities (at least in the same time frame). This reduces the net interest generated by the REIT and can, at the same time, reduce the value of the agency backed mortgage securities it holds.

There are other risks. Agency REITs make complex calculations concerning the rate at which the mortgages that underlie its securities will be prepaid. When the actual rate of prepayment takes an unanticipated direction, the yield on and value of the securities can change for the worse.

I am also concerned about a kind of Black Swan event here. If the Federal government withdrew its guarantee of these securities or announced that in the future no more securities would be guaranteed, it would certainly undermine the business model. Investors should also be concerned about the possibility that a refusal to increase the debt ceiling could create a perception that the Federal government would default on its guarantee of these securities. Even if no default actually occurred, the perception that it might occur could undermine the value of the securities and force a wholesale liquidation of the securities. Given the leverage that Agency REITs employ, a relatively small decline in the price of the securities could create collateral problems and, at a minimum, require retrenchment on unfavorable terms. Of course, an investor is being paid a very nice yield to take all of these risks.

Many of these companies have very sophisticated managements that are aware of these issues and are constantly monitoring developments and hedging. Unfortunately, quite a few of the companies are relatively young and so an investor does not have a long track record to review. In this regard, NLY is by far the largest of the group and has weathered quite a few storms very successfully. NLY's website and annual reports provide a great deal of useful information. I would certainly include it in any portfolio of these stocks I was setting up. I think it is wise to invest in a mix of these as different managers use different strategies and, depending upon how events unfold, may respond differently in the market to a crisis.

Several weeks ago I sensed that everyone was concerned about the prospect of rising interest rates and was gun shy about this group because of the dangers that rising rates would portend. Now, we are back to taking Bernanke's "extended period" language seriously and it appears rates will stay low for a long, long time. In such an environment, there is a compelling argument for including some of these stocks in any income oriented portfolio. The name of that argument is - YIELD.

Disclosure: I am long NLY, HTS, AGNC.