Agency Mortgage REITs Likely To Benefit From Ben Bernanke's Probable Comments Today

by: Zvi Bar

On Wednesday, June 20, Ben Bernanke, Chairman of the Federal Reserve, is slated to speak and provide some guidance as to the outlook forecast by the Federal Open Market Committee, and the actions that the Fed may take in response to this outlook. Many argue over what actions Mr. Bernanke may announce, or possibly imply, with the most popular guesses being QE3, twisting again (like the Fed did last summer), or Mr. Bernanke stating that things are going within the Fed's range and maintaining its prior low rate policy extension.

Though I have no clue what Ben Bernanke may state today, I do expect that the information will be either neutral or positive for agency mREITs. Agency mREITs own securities issued by federal agencies, and which come with the implied backing of the United States. Agency mREITs leverage the spread between borrowing costs and agency RMBS yields, and tend to distribute high yields that are comparable to bonds that are rated as junk.

These agency mREITs are primarily concerned with rising interest rates and accelerated prepayment rates. Many of the agency RMBSs are held and valued at a premium, but carry with them the potential of being called by the issuer at par. If interest rates go too low, prepayments will increase, while if interest rates go up too quickly, the leverage could result in multiplied losses.

Nonetheless, here, there are several reasons to believe that the Federal Reserve would not do anything drastic, including that this is an election year and it would be peculiar to see the Federal Reserve act in a manner that could shock the economy. The Fed is generally supportive of the President. This is regularly the case for Mr. Bernanke, who has served under Presidents G.W. Bush and Obama, as well as his predecessor, Alan Greenspan.

Exogenous issues, including Asian cooling and European sovereign fears, are likely to play heavy into whatever conclusions the FOMC reached. The Fed is also likely to note that oil and gas prices have declined, as have most commodity prices compared to a year ago, and that housing starts continue to indicate that a turnaround may be underway, though still in its infancy. Moreover, the banks continue to deleverage, and the foreign appetite for U.S. Treasuries has been strong, especially due to those exogenous issues.

Most mREITs are going into this report with reasonably positive tailwinds. Some of the largest agency mREITs, including Annaly Capital Management (NYSE:NLY), the largest agency mREIT, American Capital Agency (NASDAQ:AGNC) and Hatteras Financial (NYSE:HTS) recently declared their Q2 dividends. These three mREITs are generally the most broadly held agency RMBS focused REITs and financials. All three also recent announced their dividends, maintaining their Q1 dividends into Q2, though all three are yielding less than they did last year.

Hatteras and Annaly will both pay ten cents less this quarter than they did on their dividends for the same quarter in 2011, while AGNC will be paying 15 cents less. On a percentage basis, Annaly reduced its dividend the most year over year (15.38%), followed by AGNC (12%) and then by Hatteras (10%). AGNC just went ex-dividend on June 19, while NLY and HTS both go ex-div next week. Some individuals are wary of investing in mREITs immediately following an ex-div, because secondary offerings following them are common, but NLY goes ex-div and also HTS goes ex-div next Wednesday, and so some short-term traders may be looking for a minor pop between their June 19 announcements and their June 27 ex-div dates, with or without staying for the dividend.

Also, agency mREITs have performed well during and following Ben Bernanke's last few statements. Last summer, in August, the Federal Reserve Board stated that it would keep the Federal Funds Rate near zero through mid-2013. The reasoning by the Fed was due to a diminished economic outlook, and several agency mREITs appreciated dramatically in response to the statements.

Then in January of this year, Ben Bernanke further extended its commitment to keep the Federal Funds Rate low, which was supportive of agency mREITs, as well as Treasuries. Beyond the individual agency mREITs listed above, and several other agency mREITs, there are also two exchange traded funds dedicated to the mortgage REIT industry. Index funds for mREITs include the FTSE NAREIT Mortgage REIT Index ETF (BATS:REM) and the Market Vectors Mortgage REIT Income ETF (NYSEARCA:MORT) have exposure to these agency REITs, but also have some non-agency and also commercial mortgage REITs exposure.

Agency mREITs, and the agency debt that they hold, have been among the best performing equities year to date. Agency mREITs have generally appreciated and also paid out substantial dividends, with most of the gains being predicated on their U.S. government affiliation. The Fed's statements are most likely to be supportive of the asset class and remove further near-term uncertainty by stating things are continuing as according to plan as possible in a complicated and interconnected global economy that continues to need U.S. dollars and debt as a safe-haven.

As good as low rates have been to agency mREITs, they have not benefited as much as long term U.S. Treasury bonds have this year, or in 2011. Nonetheless, mREITs allow a passive investor a more automated method of harvesting a greater amount of immediate income and/or removing capital from the initial investment without engaging in continuous cost generating transactions.

REITs must distribute at least 90% of their taxable income in order to eliminate the need to pay income tax at the corporate level. Under the current tax laws, mortgage REIT dividends are taxed as ordinary income, and not at the lower corporate dividend rate. If one purchased a 20-30 year Treasury bond one year ago, selling it for a long term gain now would have been a dramatically superior investment in a taxed account, and relatively equal to holding an above average mREIT in a tax exempt account. U.S. Treasuries and agency RMBSs have about the same risk profile, and most mREITs try to hedge some of that risk, with hedging accounting for a portion of their above-mentioned relative comparable underperformance.

Whether or not the Fed announced QE3, more twisting or something else, NLY and HTS will still each have the benefit of their ex-dividend coming next Wednesday. With each yielding enough that their quarterly payout is greater than the annual yield of the S&P 500 or a 10-year Treasury, both are likely to generate some interest.

Disclosure: I am long NLY.