Author: John Gerard Lewis, Gerard Wealth
Covestor model: Stable High Yield
Disclosure: Gerard Wealth Management, Inc. is long AGNC.
To be sure, “high yield” connotes “high risk”. High-yield bonds suggest principle vulnerability. Companies may offer eye-popping dividends because they’re unable to produce sufficient funding through operations.
Hence, high yield may well mean that another shoe is dangling and may fall eventually.
So what of mortgage real estate investment trusts, those exotic creatures that divine magical yields by leveraging one end of Ben Bernanke’s policy against the other?
The short answer is that mREITs are different. Their lofty dividends aren’t necessarily red flags, but are ordinary elements of their business model. And notwithstanding a steady stream of negative commentary, mREITs remain a healthy corner of the financial sector.
One of the best managed is American Capital Agency Corp. (AGNC), and there is much to recommend ownership of this stock.
Mortgage REITS, such as AGNC, borrow at short-term rates to reinvest in pools of higher-yielding mortgage-backed securities. They are able to squeeze out attractive yields from that arbitrage, such as AGNC’s current 16.7% payout. Who needs price appreciation when you can sit back and collect that kind of return?
Well, nobody. But you don’t want price depreciation, either. And you’d rather not have “dividend depreciation”. Both, alas, can happen, so the prospects for these stocks must be carefully evaluated on their fundamentals.
In AGNC we have company that had a fourth quarter (Dec. 2011) return on equity of 18.48%, among the best in the agency-backed mREIT sector. But what is particularly impressive was its constant prepayment rate (CPR) of just 9%, which was up just slightly from 8% in the third quarter. CPR reflects the rate of mortgage payoffs in the company’s portfolio, which in a declining interest rate environment causes the mREIT to invest in lower yielding mortgage securities. That, of course, squeezes the yield spread for the mREIT.
Doomsayers over the past several months have been citing the prospect of rising CPRs as tantamount to the death knell for mREITs. (For some reason, they think it’s all or nothing – even if CPRs rise somewhat, these stocks can still likely produce healthy, if lower, dividends.) But CPRs for most agency mREITS have actually remained fairly steady, suggesting that most of the prepayments may have already occurred. After all, nobody’s waiting on rates to go lower, and at some point there will be no more properties to refinance.
AGNC president Gary Kain said in the company’s Feb. 7 earnings call that the company remains “confident that the prepayment speeds in our assets should stay muted despite record low mortgage rates.” He added that the firm has very little exposure to the government’s Home Affordable Refinance Program that allows homeowners to refinance at low rates. That program continues through December 2013.
Like most mREITs in the past couple of quarters, AGNC cut its dividend in response to external variables such as the aforementioned prepayments and Operation Twist, the Federal Reserve’s program to reduce medium- and long-term rates. But it appears that the company is not anticipating any more dividend cuts in the foreseeable future. “We believe the dividend should be sustainable for a reasonable period of time,” Kain said.
It’s key to remember that mREITs are bought for yield and not necessarily price appreciation. Even with AGNC’s 2%-3% price decline over the past year, its total return, with the outsize (though reduced) dividend, has exceeded 20% (as of March 15, 2012).
In this category of stocks that is well positioned amid continuing low interest rates, AGNC is an investable choice.
