It has been almost four months since I last wrote about agency mortgage real estate investment trusts (REITs). Given the recent renewed interest by financial types about the Fed preparing to "normalize" interest rates, this is a good time to discuss the REITs again.
In the past four months, the price for five of the six agency mortgage REITs I wrote about last February has increased and the magnificent dividend income stream on all six has remained in double digits as a percentage of their price. In this same time frame, shares of Annaly Capital Management (NLY) shares are up 7% and offer a 10.3% dividend and CYS Investments (CYS) shares are up 8% and offer a 14.4% dividend. Chimera Investment (CIM) is unchanged with a 11.7% dividend and American Capital Agency (AGNC) is up 8% and offer a 11.2% dividend and Capstead Mortgage (CMO) is up 4% and offer a 10.5% dividend. The only one that is down is PennyMac Mortgage Investment Trust (PMT). It declined in price by 10%, but is still paying a dividend of 11.2%.
Rising asset values producing double-digit income streams in a passive liquid investment is about as close to income investing nirvana as you're going to get. But income investors are avoiding the space. They believe it's too good to be true, but I don't.
The primary reason for the 10%-plus dividends in this space is that the prices for the REITs are depressed. This is because of fear of a repeat of last year's crushing losses of about 40% within four months as long-end yields rose. However, the outsized dividends in comparison to other income vehicles have remained substantially stable throughout this episode, and I believe that will continue.
Further, the current prices for five of the six have only recovered about half of what they lost last year -- even as Treasury yields and mortgage rates have continued to decline this year. As good as this performance is, it sill indicates that they are already priced for an increase in long-end yields and mortgage rates.
Yet the fear of a replay of last year's spike in yields and rates remains and it is exacerbated by enormous confusion and disagreement within the financial community about the outlook for economic activity, inflation, interest rates, Fed policy and, most importantly, to how REITs operate.
Last year's rout from REITs as interest rates rose showed that investors understand that rising interest rates reduce the value of the mortgages held by a REIT. This is then reflected by the price of the REIT declining.
However, interest rates are a double-edged sword for REIT's and their investors. Declining rates can also negatively impact a REIT's real value, its dividend income stream, by causing accelerated prepayments of the existing mortgages they hold.
When mortgage rates decline, refinance transactions increase. When that happens, an increasing percentage of the mortgages a REIT owns are paid off in full as the mortgagor refinances to a new lower rate. The REIT must then purchase new lower yielding mortgages with the cash it received from the payoff of the higher yielding mortgages.
Although this causes the value of the mortgages they hold that aren't refinanced to increase -- and, thus, push up the total spot value of their retained mortgages -- it also reduces the income the REIT may distribute to its owners. The new mortgages are yielding lower returns because they are accruing at lower interest rates. Income investors need to be especially mindful of both scenarios.
The events of last year will not likely be repeated. Even though it was irrational, the spike in long-end yields and mortgage rates was not unforeseen. It was the result of a failure of monetary policy leadership. I had warned about the potential for it to occur in January of 2013.
As the failure of monetary policy leadership and guidance continued during the first half of last year and rates started rising in May, I wrote about the probable consequences again in June, twice in July, and again in August:
- Rising Rates Trigger a Flashback to 1994
- Lessons From 1994 on Rates and Housing
- Two Fed Lapses Are Pushing Rates Higher
- Mortgage Rates Are Rising Faster Than Ever
I suggest re-reading all of those columns because what happened last year didn't need to. By August, however, the damage had been done and investors in all kinds of housing related issues had been hurt.
The irrationally low pricing of REITs right now is reflecting investor's fear of another repeat of last year's monetary policy debacle. I don't think that will happen but I am concerned that the Fed is again not making clear to the markets what its policy plan is. I'll discuss that next week.