The Uncertain Future of Mortgage REITs in a Post-QE WorldBy Michael Flannelly | Published June 28th, 2013
If you take a look at Dividend.com’s High Yield Dividend Stocks List, you will find many mortgage REITs near the top of the list, along with MLPs and other trusts. Many of these stocks offer dividend yields over 15.00%, and as a result, mom and pop investors have poured money into the stocks, allured by the big payouts at a time when it has been difficult to find attractive yields in other investment vehicles such as bonds and CDs. However, investors need to be wary about falling under the spell of these high dividend-yielding mortgage REITs; the payouts may not always last. Especially as the Federal Reserve winds down its quantitative easing, investors should be prepared to see mortgage REITs slash dividend payouts and subsequently see share prices fall.
A Little Background on Mortgage REITs
Mortgage REITs are called real estate investment trusts, but they do not make their money by owning actual real estate like a normal REIT. Instead, these companies use leverage (borrow money) and buy up mortgage-backed securities that presumably yield a higher rate than the borrowed money. The difference between the borrowed money’s interest rate and the mortgage asset’s yield is known as the spread, and this is where these companies make their profits.
With interest rates at historic lows over the past five years, mortgage REITs have been able to borrow at extremely low rates to buy up said mortgage-backed securities (MBS). The large spreads between low interest rates and the MBS yields have caused the mortgage REITs to makes substantial profits, leading to an attractive distribution of earnings to shareholders through dividends.
However, profit making in this low interest rate environment hasn’t been quite that easy for mortgage REITs. In fact, they have had a little competition in the mortgage-backed securities market by the same institution that caused interest rates to be so low in the first place, the Federal Reserve. The Fed has been buying up mortgage-backed securities on and off since 2008 as part of its quantitative easing program. This mortgage bond-buying by the Fed eventually caused increased demand in the market, which has led to rising bond prices and thus falling yields, putting a strain on mortgage REIT spreads. Nonetheless, mortgage REITs had been able to withstand the love/hate relationship of the Fed, bringing in substantial profits and thus paying out attractive yields throughout the central bank’s asset purchasing program.
Until October of 2012, that is, when the Federal Reserve began an open-ended mortgage-backed securities buying program known as QE3. It seemed as though QE3 finally caused the spreads for mortgage REITs to narrow, too, with borrowing rates rising slightly and MBS yields falling. Share prices for mortgage REITs of all kinds began to decline as profits dipped and dividends were cut, leading to a vicious cycle of further sell-offs.
It’s been a murky environment for mortgage REITs since the onset of QE3, but it is unclear if the end of QE will solve the problems that they face going forward.
What’s in Store for Mortgage REITs as QE Winds Down?
Federal Reserve chairman Ben Bernanke gave testimony in front of Congress on May 22, where he suggested that the Federal Reserve might soon slow down its quantitative easing; this caused the markets to react quite negatively. Just the mere thought of the end of QE caused investors to fear the inevitable, that the easy money would soon be over. As a result of the market reaction, stocks, bonds and commodities all sold off a bit, paving the way for tremendous uncertainty going forward in the financial markets.
Bonds, specifically U.S. Treasuries, were among the assets that took a hit due the fear of the Fed’s tapering. The bond sell-off actually began at the beginning of May, but it really picked up steam once Bernanke opened his mouth at the Congressional testimony and his post-FOMC press conference on June 19. Investors began to fear that the Fed would no longer support the bond market with its huge demand, so they began to sell. Bond prices fell and yields rose, adding to the volatility that assets like stocks and commodities experienced as well.
This bit of bond volatility has had a negative implication for mortgage REITs. Though the tapering and eventually end of QE will mean that the yields of mortgage-backed securities will rise, it also means that borrowing costs will rise as Treasury yields rise. As borrowing costs rise, it will put pressure on mortgage REITs’ spreads, eating into potential profits for mortgage REITs and possible result in losses, and thus lower dividend payouts. With interest rates rising, and expected to reach to historically normal levels in the near to medium future, this cycle will only be compounded going forward. And as dividends are cuts, investors will continue to sell mortgage REIT stocks, leading a vicious cycle that retail investors want to avoid.
Furthermore, investors should expect mortgage REITs to begin to de-leverage, meaning they will start to reduce the amount of debt they use to purchase mortgage-backed securities to reduce risk and exposure that borrowing has caused. This de-deleveranging will be another way that mortgage REITs will see their profits and dividend payouts wither away, yet another negative development that investors will begin to see.
Just take a look how some big name mortgage REITs have fared in this new QE3 and anticipated post-QE environment. In the week of June 17, a number these stocks declared dividends that were significantly lower than their previous payouts.
- American Capital Agency (AGNC), down 21% year-to-date, cut its dividend by 16% on June 18.
- American Capital Mortgage Investment Corp (MTGE), down 25% year-to-date, cut its dividend by 11% on June 18.
- Annaly Capital (NLY), down 9% year-to-date, cut its dividend by 11% on June 19.
- Invesco Mortgage Capital (IVR) did not cut its dividend payout, but it is down 15% year-to-date.
While these stocks still maintain substantially higher-than-average yields, it should cause a bit of concern for income-seeking investors wanting stable dividend payouts. Also, as evidenced by their year-to-date performance, it shows that investors have not benefited from the share price appreciation aspect of the stocks as well. It has been a tough go for mortgage REITs, and it does not look to be getting better any time soon.
The Bottom Line
Mortgage REITs, to say the least, are not for the faint of heart. For investors that need stable income month after month, quarter after quarter, try not to be allured by the eye-popping yields that mortgage REITs provide. The volatile price action and potential losses could eradicate any upside that their high-than-average yields provide. These assets have an uncertain future going forward, and though they make it out on the other side of QE unscathed, it is not recommended that investors take this journey with them.