Twin benefits
Capstead Mortgage Corporation (NYSE:CMO) is one such mREIT that has the potential to offer sustained dividends, coupled with capital appreciation over the coming quarters. One of the major reasons for this outperformance is the nature and design of its asset portfolio.
The company’s charter allows it to invest exclusively in the adjustable-rate Agency residential mortgage backed securities. Given the prevailing rising rates environment, these securities provide twin benefits of higher earnings potential and protection against book value erosion.
The adjustable-rate mortgage backed securities adjust their periodical payments to more current rates on the upcoming reset date. Because their payments are based on the prevailing rates, their prices don’t fluctuate as much, compared to the prices of fixed-rate securities. Therefore, they tend to provide some book value protection. On the other hand, since their payments are adjusted to more current rates, they tend to offer higher yields under the current rising rates environment. While the earnings potential is enhanced over the longer-term, book value protection happens immediately.
A look at the second quarter results also proves my point. During the second quarter, Capstead Mortgage Corporation (NYSE:CMO)’s book value plunged only 5.6% over the first quarter. This is one of the lowest book value declines for an Agency-only mREIT this quarter. Also, during the second quarter, Capstead Mortgage Corporation (NYSE:CMO) reported a 15 basis point decline in its net interest rate spread. The net interest rate spread is a key earnings matrix for mREITs. The decline in the second quarter spread is also one of the lowest compared to its peers.
The company offers a dividend yield of 10.3% on its quarterly shareholder distribution of $0.31 per share. The past four quarters’ cash dividend coverage ratio leads me to believe that this quarterly shareholder distribution is fairly sustainable. The company has an average cash dividend coverage ratio of 1.65 times, which means it has been able to generate 1.65 times higher operating cash flows than the quarterly dividend payments. The stock is currently trading at $12.01 per share, while analysts have a consensus mean target of $13.15 per share. This gives upside potential of 9.5% and a total return of nearly 20%.
Defensive portfolio
American Capital Agency Corp. (NASDAQ:AGNC) is another Agency-only mREIT I am bullish on. The company’s charter allows it to invest exclusively in fixed-rate Agency residential mortgage backed securities. It is one of the very few well managed mREITs in the industry.
The company has shown its resolve to get rid of some of the long-term (30-year) fixed rate Agency MBS and add more 15-year MBS. The 15-year MBS make up around 40% of its entire asset portfolio. The price of the 30-year MBS has the highest sensitively to changes in interest rates. Therefore, its abundance causes significant book value declines. The 15-year MBS has less price sensitivity to changes in interest rates. So, the management’s resolve will preserve the book value against further declines.
Now, how does it ensure higher earnings potential? The reduction in the 30-year MBS will lead to lower earnings, so to offset this, the management has decided to actively manage its assets and hedges to capture and create attractive investment opportunities when they present themselves. So, with higher earnings potential and book value protection, American Capital Agency Corp. (NASDAQ:AGNC) is all set for a bright future.
The company offers an impressive dividend yield of 18.6%, on its quarterly shareholder distribution of $1.05 per share. It’s fair to believe that this quarterly distribution is sustainable as its four quarter average cash dividend coverage ratio comes out to be 1.55 times. This means, it is generating 1.55 times more cash than is required in dividends. Also, it means that the company can tolerate some spread contractions before a dividend cut is evident. Analysts have a consensus mean target of $25.47 for the stock that is currently trading at $22.59 per share. This gives the stock upside potential of 12.75% and a massive total return of 31.4%.
Diversification benefits
This was evident when it reported its second quarter results with 7.4% sequential decline in the book value, coupled with a 6 basis point increase in the net interest rate spread. Lower book value decline and higher earnings during the quarter were a direct result of the diversification provided by the company’s investment portfolio.
The stock currently offers a dividend yield of 11.13%, and its quarterly dividend rate is $0.28 per share. The company has a relatively weak four-quarter cash dividend coverage ratio of 0.93 times. However, an expanding net interest spread offsets this concern. The stock is currently exchanging hands at $7.91 per share and offers upside potential of 9.1%. This makes the total return potential to come out to 20.23%.
Conclusion
While chasing the mortgage REITs’ elevated dividends yields, you must be certain that any capital depreciations don’t offset the benefits of these elevated yields. I believe MFA Financial, Inc. (NYSE:MFA), American Capital Agency Corp. (NASDAQ:AGNC) and Capstead Mortgage Corporation (NYSE:CMO) offer sustainable dividend yields. Analysts believe they have the potential to provide capital appreciation for the aforementioned reasons. So, I am bullish on these stocks.
The article Chase These mREITs originally appeared on Fool.com and is written by Adnan Khan.
Adnan Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Adnan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.
