Sell These 2 Popular Finance REITs Entering the Danger Zone

Accelerating Dividends, Real Estate Investment Trusts (REITs), Stocks to Avoid

After a decade of zero percent short term rates and 2.0 to 2.5% long term Treasury rates, the interest rate yield curve has started to make dramatic shifts. The financial news coverage seems to shift daily between the dangers of a flat yield curve and the dangers of a rising yield on the 10-year Treasury. These two outcomes are quite mutually exclusive, but either scenario is a danger to the finance REITs that own large portfolios of residential mortgage securities. These high-yield stocks are not the place to gamble on the direction of future interest rates. Losing that bet will cost you more than you are likely willing to lose.

Residential mortgage REITs buy what are called residential mortgage backed securities (MBS), which are bonds backed by pools of residential mortgages. The majority of residential MBS hold loans guaranteed by one of the governmental agencies, like Fannie Mae, Freddie Mac, and Ginnie Mae. With the agency backing, these mortgage securities have AAA credit ratings. The top rating gives investors safety of principal, but also result in low yields on the bonds. For example, agency 30-year mortgage MBS currently yield around 3.5%. It takes large amounts of leverage for one of these REITs to pay 10% or 11% dividend yields. By leverage I mean a REIT borrows money to buy MBS. These companies will leverage their equity 5 to 8 times, and most of the cash to pay dividends comes from the difference between the yields on the MBS and the short term borrowing costs.

If the yield curve flattens, the interest rate spread on which a residential MBS REIT depends will shrink. A tightening spread can quickly reduce cash flow, a flat yield curve means no money to pay dividends, and an inverted yield curve means big losses for the REIT. The other potential challenge is rising long term interest rates. If this happens, the market prices of MBS bonds will fall. Lenders providing the leverage will force the REITs to sell bonds at a loss. The result is a shrinking portfolio which means less interest income flowing into the business to cover expenses and dividend payments. The agency residential MBS REIT business model needs the Goldilocks scenario of a positively sloped yield curve and interest rates that are stable to declining.

Here are two popular agency MBS REITs whose futures will be negatively affect by current interest rate forecasts.

AGNC Investment Corp (Nasdaq: AGNC) is one of the largest agency MBS REIT. NLY and AGNC are the two largest companies in this REIT sector. As of the 2018 first quarter AGNC owned $54.8 billion of agency MBS. This works out to 8.2 times leverage of the company’s equity.  The company had $49.0 billion of debt. AGNC also earns dollar roll income in the MBS TBA (to be announced) mortgage trading.

At the end of the quarter the company had a $13.6 billion TBA position Reported net interest spread for the quarter was 1.26%. A year earlier the spread was 1.51%. This narrowing shows the effects of a flattening yield curve.

The company report net spread and dollar roll income of $0.60 per share and paid dividends of $0.54 per share. AGNC has some cushion against higher short-term rates, but that is because the company has reduced the dividend by 10% in each of the last two years to stay ahead of fallen net interest income.

Annaly Capital Management, Inc. (NYSE: NLY) is an agency MBS owning REIT that has an almost equal market cap to AGNC. In its 2017 third quarter earnings report the company owned $104.3 billion worth of mortgage securities. Of this total, $88.5 billion was agency MBS. The company owns $16 billion of other assets, including $5 billion of commercial property mortgages. This large pile of assets is held aloft by a total of $87.3 billion of debt.

In the quarter, Annaly reported a net interest rate margin of 1.52%. That margin resulted in core earnings of $0.30 per share for the quarter. The current dividend is $0.30 per quarter.

The company actively hedges its interest rate risk and has been diversifying its business lines. However, this company is largely dependent in its leveraged agency MBS portfolio and hedging can only protect for slow changes in interest rates.

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