Mortgage REIT Review Redux

 | Aug 19, 2014 | 5:00 PM EDT
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For the past year I've been writing about mortgage real estate investment trusts (REITs) about every three months, and it's time to do so again since I last discussed the sector in May. One of the original reasons for writing the column "ABCs of Real Estate Investment Trusts" last November was that prices of the REITs had been crushed in 2013 as the 10-year U.S. Treasury yield spiked on fears of the Federal Reserve tapering stimulus. That dragged mortgage rates up, causing housing activity to crater and in the process smashed the value of the mortgages held by the REITs.

Even though the 10-year Treasury yield has declined steadily in 2014 to 2.37% from 3%, causing mortgage rates to decline and the value of the mortgages held by the REITs to rebound, the fear of a replay of the 2013 rate spike has precluded many from venturing back into the space. And that's a good thing.

The traditional REIT shareholder is an investor who's there for the income REITs produce. These same investors typically are also interested in the stability of the underlying value of their principal. As rates spiked last year, even though the dividend streams remained secure, many income investors fled the REITs and that caused a dramatic decrease in their share prices.

From the current perspective, those may be considered to be the weak hands; the investors who bought for the substantial income the REITs produced but discovered after the fact that their comfort level with a fluctuating asset price (as a psychological cost to be incurred to access that income stream) was beyond their comfort level. That has resulted this year in share prices for REITs that, although rising, are mostly very stable.

That also implies that even if there is another rate spike, any declines in the share prices of the REITs will be mitigated by the fact that the weak hands left in 2013 and have not returned. One of the reasons for their failure to return is the persistent expectation of rising Treasury yields and mortgage rates that is almost ubiquitous throughout the financial media. For REIT investors, though, this has a counterintuitively positive impact on the REITs by weeding out the weak hands before they buy and results in stable share prices for the stronger hands that remain.

The perfect scenario for a REIT investor is a stable share price with higher income creation and distribution. The stable share price prevents speculators and traders from participating and creating or gaming volatility, while the fear of such keeps weak-handed investors out.

In the past three months, the share price appreciation for five of six of the mortgage REITs I've been tracking in this series of columns has been below that of the S&P 500, with one just slightly above; but all are positive and all are still producing dividend yields in excess of 10%.

Shares of Annaly Capital Management (NLY) and American Capital Agency (AGNC) are sideways in the past three months while still providing dividend yields of 10.3% and 11%, respectively.

Capstead Mortgage (CMO) is only up about 1% but also maintains a dividend yield of 10.2%.

PennyMac Mortgage Investment Trust (PMT) had declined about 10% in the four months leading up to the column I wrote on the subject in May, but it has since rebounded with about a 4% appreciation in the past three months and still provides a dividend yield of 10.6%.

CYS Investments (CYS) has appreciated at about the same rate in the past three months but has a dividend yield of 14.5%.

The only one of the six to exceed the appreciation of the S&P 500 in the past three months has been Chimera Investment Corp. (CIM), with a gain of about 5.2% vs. the S&P 500's 4.6%. In the past six months, though, Chimera's appreciation is about half that of the S&P 500 and it still has a dividend yield of 10.8%.

One aspect of this stable performance that investors should be aware of is that the appreciation of the share prices of REITs has been less than the implied appreciation of the mortgages they own, which was caused by the substantial reduction in long-end Treasury yields and mortgage rates this year. Although something may cause Treasury yields to spike again, the secular trend toward lower long-end Treasury yields that's been in force for more than 30 years remains. I'll write more about that later this week.

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