Author: John Gerard Lewis, Gerard Wealth
Covestor model: Stable High Yield
One invests in any security in consideration of prospects for the foreseeable future. At this time, the most important fundamentals to consider for mortgage real estate investment trusts are prepayment rates and interest rates.
First, let’s look at prepayment rates, which affect the yields of mREITS. Over the last five months of 2011, refinancings slowed by 28% according to the Mortgage Bankers Association. That has served to mitigate the prepayment risk for these stocks.
Whither interest rates? Does the most recent jobs report signal the sudden commencement of boom times, which would finally allow the Fed to raise rates? We don’t think so. It was just one report, and it did not take into account the millions who have simply dropped out, i.e., who have become so discouraged that they’ve quit looking for employment. Moreover, the Fed in January announced that it is committed to maintaining its low interest-rate policy well into 2014. It would take a heavy dose of humility for Chairman Ben Bernanke to back away from that pronouncement very soon.
What this means for mREITS is that the coast appears generally clear as to rising rates. There remains, of course, the matter of a tightening spread between short- and long-term rates, which has occurred somewhat since the initiation of Operation Twist, the Fed’s initiative to lower long-term rates. Such tightening has the effect, theoretically, of reducing the yields of mREITS, which have, in fact, reduced their dividends in recent months. This, according to DoubleLine Capital’s Jeffrey Gundlach, is reason enough to now avoid them altogether.
We aren’t married to mREITS, but that seems a little drastic to us. Even after the dividend cuts, yields remain in the double digits. We know of one pundit who posits the notion that fluctuations in mREIT dividends correlate with changes in their stock prices. We would not dispute that surmise out of hand as it may have some merit, but neither would we blindly accept it as the linchpin of an investment decision.
Here’s why: selectivity matters. Of the six mREITS that we hold in our Stable High Yield model, all have cut their dividends since July 1, 2011, but just one has declined more than 6% in price (through Feb. 7, 2012). The 14% decline in that stock, Anworth Mortgage AssetCorp. (ANH), roughly tracks a 16% cut in its dividend over that time. But among our holdings, ANH appears to be an outlier.
CYS Investments (CYS) cut its dividend by 17%, but its price had actually risen by 3% (again, as through Feb. 7, 2012). American Capital Agency (AGNC) and Capstead Mortgage (CMO) cut their dividends by 11% and 10% respectively, but their prices had remained relatively flat. And Annaly Capital Management (NLY), despite cutting its dividend by 12%, was down only half that over the period.
Thus, the average price decline of these six holdings has been 3% amid an average dividend cut of 13%. There’s no meaningful correlation there. A more extensive analysis over a longer period of time might reach a different conclusion. For example, perhaps price declines anticipate dividend cuts. But we haven’t observed that to be a general rule since our model’s inception date of July 8, 2011.
The average annualized yield of our six mREITs is a healthy 14% (as of 2/7/12), but as with any sector, especially high-yield instruments, no investor in mREITS should go “all in”. Diversification and risk mitigation are critical to our strategy. That’s why we buttress the aforementioned risks with a substantial allocation to low-beta short-term bonds. The balance of the portfolio consists of a small commitment to Build America bonds and a master limited partnership.
The objective is to achieve equity-like returns by pairing high-yield and short-term instruments. Constant monitoring is required, but we believe the objective will be realized over the foreseeable future, notwithstanding the dividend cuts.
