The mortgage REITs sector witnessed a rally late last week with all the major mREITs posting gains. While the stock market rally was partially the reason why the mREITs were lit up in green, the dividend announcements by some of the mREITs were the primary reason. I believe the rally will be short lived, and investors should look at the future approach of each of the mREITs before making an investment decision.
mREITs lit up in bright green
The sectors’ ETF (REM) posted a 4.8% surge, while Western Asset Mortgage and CYS Investments Inc (NYSE:CYS) were leading the gains with 8.2% and 7.5%, respectively. The larger players, American Capital Agency Corp. (NASDAQ:AGNC) and Annaly Capital Management, Inc. (NYSE:NLY), also posted 5.3% and 5.4% increase in their stock prices, respectively.
Dividend upsets
Given the prevailing volatility in the interest rates, analysts were thinking that mortgage REITs will face significant downward pressure on their book values. Also, these highly leveraged corporate structures will face volatility in their returns. Their conclusions were leading to dividend cuts across the sectors, particularly with ARMOUR Residential and JAVELIN Mortgage Investment. However, they were both able to maintain their dividends, and I believe their future approach should be to rebalance/restructure their investment portfolios to better suit the current environment.
ARMOUR and JAVELIN were not alone. Capstead Mortgage Corporation (NYSE:CMO) and CYS Investments Inc (NYSE:CYS) also maintained their dividends for the second quarter. An upset was Two Harbors Investment Corp (NYSE:TWO)‘s dividend cut. Among the REITs that reported their coming quarter’s dividends, only Two Harbors Investment Corp (NYSE:TWO) and JAVELIN are hybrid, while the rest are exclusively invested in Agency residential mortgage backed securities.
More hedges are the future here
Analysts at Credit Suisse were expecting Two Harbors Investment Corp (NYSE:TWO) to maintain its quarterly dividend at $0.32 per share, while the company slashed its dividend by 3% to $0.31 per share. Even though the dividend cut is not massive, still it’s a disappointment, considering the level of diversification the company offers in its investment portfolio. Remember, Two Harbors remains Credit Suisse’s top pick.
I believe the company needs to needs to reduce its leverage and add more hedges to help mitigate the book value impact during the quarter. In this regard, Two Harbors had already disclosed recently that it had gone from over $2 billion long TBA position to over $2 billion short TBA positions during the current quarter.
Two fold benefits
Similarly, I was expecting Capstead Mortgage Corporation (NYSE:CMO) to report a dividend hike. However, it declared a dividend in line with its previous dividend. Capstead Mortgage Corporation (NYSE:CMO) is exclusively invested in adjustable-rate Agency residential mortgage backed securities. Since they adjust their coupons to the current interest rates, they were expected to increase the company’s net interest rate spread.
Besides, since the securities adjust their coupon payments on every reset date, their book values are least exposed to changes in the interest rates. So, in the coming future, the company is expected to benefit two fold because of the large concentration in adjustable-rate securities.
Excess capital could be a headwind for profitability
CYS Investments Inc (NYSE:CYS)’ announcement did not surprise the market as it was already expected to maintain its prior dividend rate of $0.34 per share. Barclays expects the stock to increase its dividends over the next three quarters and to be able to generate solid double-digit returns. A large number of repo counterparties and excess capital are among the key factors that will protect CYS Investments Inc (NYSE:CYS) from the volatile interest rates.
Currently, management is holding about 833 bps in equity for Agency MBS haircuts, prepayments, accrued interest rates, and volatility in MBS prices. This implies that it’s utilizing only 67% of its equity and maintaining 33% of total capital as excess liquidity. Given the volatility in the markets, the strategy makes sense, but it’s hindering profitability at the same time.
Conclusion
The recent dividend announcements have caused mREITs to rally. However, I believe this should be temporary. mREITs are faced with considerable volatility, which will cause them to report book value erosion. Therefore, investors looking to expand their regular income must make a decision after looking at the mREIT’s future strategy.
The article Dividend Upsets in Mortgage REITs 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.
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