The significant financial market downturn beginning in 2008 instilled a fear that has bred a constant vigil of heightened wariness. This feeling has caused many investment ideas to be targeted as the next source of market collapse.
The high current dividend yield of American Capital Agency Corp. (NASDAQ:AGNC) is enough to stop the average investor from looking further. Based on a price per share of $32.80, the $5.00 per share dividend is a whopping 15.24%. Take a look at the snapshot of financial highlights and pay close attention to the debt-to-equity ratio. The value list is 7.04, which indicates a significantly high level of debt.
American Capital Agency Corp. (NASDAQ:AGNC) generates its profits, charges management fees and passes the net income, which may be adjusted upwards by non-cash expenses, to shareholders. The portfolio is based entirely on mortgage obligations issued by the Federal National Mortgage Association, also known as Fannie Mae and once a NYSE listed stock, and Federal Home Loan Mortgage Corp, which has the nickname of Freddie Mac. These two corporate entities were the backbone of the mortgage industry and remain supported by the Federal Government.
American Capital Agency Corp. (NASDAQ:AGNC)’s model is based on buying seven times the size of obligations issued by these entities. They then manage the cash flows and risks associated with the use of current low short-term interest rates. The profits are based on the return of assets, less the cost of debt and the cost of management. What remains is distributed to shareholders, and using the high level of debt it is easy to see why such high dividends are returned.
While I believe that the prudent use of leverage to enhance returns is a viable strategy for a sophisticated investor that can afford the greater risk of loss of capital, the equity to debt ratio of American Capital Agency Corp. (NASDAQ:AGNC) offers no protection to the equity when a sharp rise in short term interest rates occurs. As a stand-alone investment, caveat emptor holds true.
The next extremely attractive dividend paying mREIT is Western Asset Mortgage Capital Corp (NYSE:WMC). The current share price of $22 and dividend of $3.80 per share gives a yield of 17.26%. Western Asset Mortgage Capital Corp (NYSE:WMC)purchases mortgages that are not guaranteed and, per the table below, is operating on a 9.16 debt-to-equity ratio.
Another significant factor is that the latest investment in mortgage obligations was made on June 12, 2009. Mortgages issued in 2008 and 2009 were at higher interest rates that generated the net income passed onto shareholders. Looking at the chart below, aside from the very high debt-to-equity ratio, sales income when compared to market capitalization gives another red flag and begs the question, “is it prudent to invest in a company that has a market capitalization of $533.85 million and yet only generates $71.70 million in sales?” In my opinion with no new mortgage investments over the course of time, the existing portfolio can only decrease in size. Such downsizing will result in lower cash inflows and dividend payments. Based on this, I do not see any long-term prospects here.
Another subject of this increased awareness is Annaly Capital Management, Inc. (NYSE:NLY). The current share price is around $15.66, and with a dividend of $1.80, the yield is 11.49%. Annaly Capital Management, Inc. (NYSE:NLY)’s investment portfolio is not based entirely on mortgage obligations; real estate is owned and operated. The link to the website lists all of Annaly’s divisions: http://www.annaly.com/site/annalyfamilyofcompanies.aspx. Per the table below, the debt-to-equity ratio of 6.62 indicates a very high level of borrowed funds to continue operations. Regardless of the various entities, the exposure to low cost short-term financing carries significant risks to its operations when the inevitable rise in interest rates begins.
As stated earlier, I support the use of leverage to enhance returns, to a certain point. I believe that a recipe for disaster is in progress when the application of such leverage is expanded to enhance the gross returns of narrowing margins. The excessive levels of debt in relation to the equity of these companies should not be ignored simply due to the high current yields. I caution the average investor to make sure that he/she is comfortable with such debt levels and feels comfortable with how the management of these types of REITs manage interest rate risk.
The article Are Highly Leveraged Mortgage REITs the Next Target of a Witch Hunt? originally appeared on Fool.com and is written by Jeff Stouffer.
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