Unmatched yields
Given the situation, where the 10-year Treasury is yielding only 2.6%, investors can harvest yields in excess of 20% if they invest in the aforementioned mortgage REITs. That’s a staggering 17.4% higher! So, retail investors find it difficult to resist such lucrative yields. Let’s look at the yields and dividend rates of the aforementioned mREITs.
Currently, Western Asset Mortgage Capital Corp (NYSE:WMC) is yielding 21.7% on its quarterly dividend rate of $0.90 per share. Javelin Mortgage Investment Corp (NYSE:JMI) pays its investors on a monthly basis. However, for better comparison I take its quarterly distribution. It distributes $0.23 per share each quarter and yields 21.12%. American Capital Agency Corp. (NASDAQ:AGNC) is paying its investors $1.05 per share and its dividend yield comes out to be 19.18%.
While the three mREITs offer elevated yields, not all are worth buying.
Risk return tradeoff
These elevated yields are the reason why we have seen so much influx of the retail investor into the mortgage REIT sector in recent times. However, it’s important to realize that the institutional investors, which are considered to posses superior investment knowledge compared to retail investors, have preferred to stay away from this sector. That’s because they understand, high return is always associated with high risk. So, what are the high risks associated with an investment in mREITs?
Mortgage REITs are complex business models that have a large dependence on the macroeconomic conditions, particularly changes in the interest rates. Currently, the interest rates are on the rise and so is the volatility in the interest rates. This has caused the interest rate yield curve to steepen. The climbing rates have caused tremendous pressure on the mREITs as they have large investments in mortgage backed securities, or MBS, that fall in value. The book value of an mREIT is important because all an mREIT has is its portfolio of fixed income (liquid) securities. If their prices fall, so does the stock price. That’s why the stock price of Western Asset Mortgage Capital Corp (NYSE:WMC), Javelin Mortgage Investment Corp (NYSE:JMI) and American Capital Agency Corp. (NASDAQ:AGNC) have sky dived 16%, 31% and 25% since the beginning of the year, respectively.
Now, the question is which of the mREITs considered in this article will be able to post the least decline in its book value.
Which is the safest?
To determine which mREIT is the safest, we need to first cut open their investment portfolios and see how much exposure they have in the long-term fixed rate residential Agency MBS. That’s because residential Agency MBS market is witnessing all the volatility.
American Capital Agency Corp. (NASDAQ:AGNC)’s charter allows it to invest exclusively in residential Agency securities. However, its management conducted a portfolio re-balancing exercise in order to reduce its exposure. Besides, reducing its holdings of the 30-year fixed rate residential Agency MBS, the management also decided to actively manage its hedges and assets. While it may secure the book value to some extent, I believe this exercise will result in a lower earnings potential in the future for the company. Since mREITs are required to payout 90% of their earnings, future earnings potential cannot be overlook.
Western Asset Mortgage Capital Corp (NYSE:WMC) is classified as a hybrid mREIT as it invests in both Agency and non-Agency MBS. Besides these investments, Western Asset Mortgage Capital Corp (NYSE:WMC) also has inverse interest-only floaters in its portfolio, which add to the benefit of the company. This diversity in the company’s asset portfolio makes it my most favorable mREIT among the three considered in this article. Overall, nearly 89% of the company’s first quarter end portfolio was invested in Agency-only securities, while the rest is non-Agency and interest-only strips.
Javelin Mortgage Investment Corp (NYSE:JMI) is another hybrid mREIT; however, it’s one of the least preferred hybrid mREITs. The company was recently downgraded by analysts at Citigroup on concerns about a significant decline in its book value. One of the major concern about Javelin Mortgage Investment Corp (NYSE:JMI) is the use of higher leverage used by the company in such volatile times (8 times, compared to 5.8 times for American Capital Agency Corp. (NASDAQ:AGNC)). Leverage tends to magnify results and will cause increased volatility in the book value of JAVELIN Mortgage. Besides, Javelin Mortgage Investment Corp (NYSE:JMI) invests a modest portion of its entire equity in the non-Agency MBS, so its financial results for the second quarter would be overshadowed by the weak performance of its Agency portfolio.
Conclusion
Given the prolonged uncertainty that surrounds the unwinding of QE3 and the resultant volatility in interest rates, mortgage REITs with the largest exposures in the high yielding non-Agency residential MBS and commercial MBS are best suited, as these securities will provide a cushion to the book value while enhancing earnings potential. Among the three mREITs considered in this article, Western Asset Mortgage Capital Corp (NYSE:WMC) is the closest to the criteria, which is why I believe it’s the best bet.
The article Chasing These 20% Dividend Yielding Stocks 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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