ARMOUR Residential REIT, Inc. (ARR), American Capital Mortgage Investment Crp (MTGE): Mortgage REITs Are Still a Sell

Like many other real estate investment trusts (REITs), mortgage REITs have sold off of late. That drop, however, doesn’t make them buys. Investors should still avoid ARMOUR Residential REIT, Inc. (NYSE:ARR), American Capital Mortgage Investment Crp (NASDAQ:MTGE), Chimera Investment Corporation (NYSE:CIM), and Annaly Capital Management, Inc. (NYSE:NLY).

The carry trade

Mortgage REITs use equity and, more importantly, debt to buy mortgages. With interest rates at historically low levels, these REITs have been able to use cheap debt to build massive portfolios. According to Fed Governor Jeremy Stein, these companies were able to effectively double the size of their portfolios in around two years. That’s a huge increase.

Such growth may sound like a great deal, but the risk is that mortgage REITs are essentially creating a carry trade. They make money from the difference between the rate at which they borrow and the rates at which they earn. If either, or both, of those rates go in the wrong direction, the business model falls apart—fast.

That can lead to dividend cuts and portfolio values falling. For evidence of the risks, The Financial Times recently noted that, “[e]very one of the most popular class of US mutual funds investing in bonds lost money in May, highlighting the risks for investors as interest rates rise.” Mortgage REITs are little more than a leveraged portfolio of mortgage-backed bonds.

Steady dividends, falling value

American Capital Mortgage Investment Crp (NASDAQ:MTGE) has done the best job of supporting its dividend, holding it steady at $0.90 a quarter for the past five quarters. However, interest rate fears have led to an over 20% drop in the share price over the last three months.

MTGE data by YCharts

The bulk of the fall, however, has occurred in just the last month or so. The shares recently offered an impressive 17% dividend yield. Clearly, the market is predicting a dividend cut. That’s not surprising since the company’s book value per share fell from $25.74 at the end of 2012 to $24.25 at the end of the first quarter. That’s a $1.49 drop, or nearly 6%, in a single quarter.

MTGE data by YCharts

Even if the company can manage to continue paying its $3.60 annual dividend, the share price drop over the last three months from around $26 to about $21 has more than wiped out the benefits of the dividend. And if the dividend gets cut, the share price could head quickly lower, too.