3 Obscure Dividend Powerhouses

Includes: AGNC, CYS, NLY, TWO
by: Dividend Millionaire
Over the last few weeks, the market has appeared to come to terms with the fact that the “new normal” (as Bill Gross termed it) of slow growth and structurally high unemployment could persist for years, if not decades. In this environment, investors would do well to focus on investing in dividend powerhouses that will be able to continue generating cash for investors. Federal Chairman Ben Bernanke essentially guaranteed an “exceptionally low” Federal Funds rate through mid-2013 in an attempt to combat this sluggishness. This action, in particular, presents a uniquely attractive environment for dividend investors to earn amazing yields in mortgage REITs.
Like BDC's, mortgage REITs represent a very special (and very lucrative) type of dividend stock. Mortgage REITs function like normal REITs except that they own mortgages (as opposed to property) and collect the coupon payments (instead of rents). Broadly speaking, mortgage REITs invest in two types of mortgages: Agency mortgages (which are guaranteed by the “government sponsored agencies” Fannie Mae, Freddie Mac and Ginnie Mae) and non-Agency (which are not guaranteed and thus, carry a higher credit risk and higher yield). In general, mREITs that invest in agency securities typically carry a higher premium to book-value (seeing as there’s virtually no credit risk in their mortgages). As a result, most agency REITs tend to use much more leverage than their non-agency peers.
By borrowing in the short-term markets (at 0-0.25%) to purchase these mortgages (yielding between 2-3%), mREITs earn the spread or “net interest margin”. Depending on the degree of leverage employed, a 2% spread can turn into an 18% dividend. We have always been a fan of using mREITs for investing for dividends as long as the interest rate environment is right. The catch with mREITs is the risk of rising short-term rates, because this increases their cost of borrowing. mREITs need a steep yield curve in order to “borrow low and lend high”. Now that the Fed has basically guaranteed this won’t happen in the near future (and likely not for long after that), investors can enjoy these big dividend payments with much more certainty than in the past. This Barron’s article seems to agree.
Annaly Mortgage (NYSE:NLY) has always been a good buy in this sector and we recommend it now. It’s been covered exhaustively, so below we spend our time highlight 3 lesser-known mREITs with an outlook as good or better than Annaly’s.
Two Harbors Investment Corp. (NYSE:TWO)
Two Harbor’s MBS portfolio is currently about 82% agency and 17% non-agency. TWO’s top two executives came from the hedge fund Pine River which had more than $3.4 billion under management as of 2010, and a focus in MBS.
Recently TWO had a secondary public offering which raised a lot of cash that now has to be deployed profitably (otherwise they risk diluting existing shareholders’’ equity). Agency MBS have enjoyed a strong run recently, making them expensive by historic standards and thus leaving TWO with fewer buying options. With the “flight to safety” in Treasuries, MBS have risen because mortgage rates (which are historically priced about 1.5-2% higher than the 10-yr) have fallen as well.
That said, TWO’s management is known for being extremely adept in the MBS markets. Furthermore, in his August letter to T2 Partners, Whitney Tilson listed TWO as one of his top investments. With a 16% dividend yield and an experienced management team with dry powder to deploy, we feel comfortable owning this cash-generating machine for the next few years.
Cypress Sharpridge Investments (NYSE:CYS)
CYS holds 100% agency MBS and is currently sporting a whopping 18% dividend yield . CYS is managed by Cypress Sharpridge Advisors LLC, a joint venture between Cypress CSI Advisors LLC (A Private Equity sponsor) and Sharpridge Capital Management, L.P. (a specialist fixed income asset management company). Management has demonstrated success at navigating the MBS sector and is known for being prudent with capital.
American Capital Agency Corp. (NASDAQ:AGNC)
Like CYS (and NLY) American Capital Agency Corp is an agency-mortgage REIT yielding over 18%. AGNC is a newer agency mREIT, launched in 2008. That said, the company has been continually successful in profitably deploying proceeds from secondary offerings keeping its book value per share around 1.15x and that has recently increased as the company is experiencing slower pre-payment rates. This is important because higher pre-payment rates, in a decreasing rate environment, mean that the company has to reinvest the proceeds at lower rates. AGNC’s decreasing prepayment rate isn’t necessarily shared by its peer group. It is entirely a function of their careful security selection. AGNC has shown since its inception that it has been able to raise funds and invest in high-quality MBS with favorable characteristics.

Given the increased and prolonged nature of uncertainty surrounding the markets these days, the commitment of the Federal Reserve to maintain "exceptionally low" short rates for the foreseeable future gives dividend investors an opportunity to borrow from Uncle Sam to make some money in the mortgage markets.

Disclosure: I am long CYS, NLY, TWO, AGNC.

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