With The Fed Spending $40 Billion Per Month, Should Investors Flee Mortgage REITs?

by: Matt Schilling

As Annaly Capital (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) continue to speak out against the Federal Reserve's strategy of buying more mortgage backed securities, is now the right time for investors to seeking alternative high-yield investments? I think it is and here are several reasons why.

The first variable to consider is the Federal Reserve's current policy regarding long term interest rates. As long as the Fed continues to rates at or near 0.00% - 0.25%, Mortgage REITs such as Annaly and American Capital run the risk of maintaining profitability. The downward push of long term rates directly affects the prepayment rates of the existing mortgages within each firm's portfolio and as prepayment rates increase, the ability to profit diminishes.

The second variable to consider is the fact the Federal Reserve is operating as pseudo-Mortgage REIT by buying an additional $40 billion of mortgage backed securities each month. Considering the fact Annaly, American Capital, Chimera (NYSE:CIM), and Two Harbors (NASDAQ:TTWO) all engage in a similar practice, such an action by the Fed directly affects not only the revenues of each firm but the profits as well. If revenues and profits are affected, the heavily attractive dividend distributions of these firms will also feel the pain, and could be cut even further then where they stand at current levels.

The third variable for potential investors to consider concerns the recent share buybacks of such companies as Annaly Capital and American Capital. In most cases share buybacks are a very good thing for potential investors as they tend to enhance the current share price of shares. For example, "If a firm's manager believes their firm's stock is currently trading below its intrinsic value they may consider repurchases. An open market repurchase, whereby no premium is paid on top of current market price, offers a potentially profitable investment for the manager. That is, he may repurchase the currently undervalued shares, wait for the market to correct the undervaluation whereby prices increase to the intrinsic value of the equity, and re-issue them at a profit". Such an action would be welcomed with open arms, except in this case both companies are up against the buying power of the Fed and don't have the funds to outspend the US government.

Where would I begin to consider alternative investment options? As an income driven investor I'd start with a conservative income strategy and use growth as an ancillary objective. One of the best places for conservative income would be the US-based Index ETFs which yield anywhere from 0.90% to 2.34%. The Powershares QQQ ETF (NASDAQ:QQQ) which tracks the performance of the NASDAQ, currently yields 0.90% and has demonstrated a year-to-date return of 15.69%. From a 'middle of the road' perspective, the SPDR S&P 500 (NYSEARCA:SPY) currently yields 1.98% and has demonstrated a year-to-date return of 11.93%. Lastly, the SPDR Dow Jones Industrial Average (NYSEARCA:DIA) currently yields 2.34% and has demonstrated a year-to-date return of 6.51%.

Disclosure: I am long AGNC, NLY, CIM. 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.