Due to the elevated dividend yields, mortgage REITs have become a retail investor’s favorite investment. Among the mortgage REITs, Anworth Mortgage Asset Corporation (NYSE:ANH) is a dominant mid cap mREIT that recently disclosed its performance for the second quarter of the current year. MREITs are faced with a lot of external factors, so their management teams must be on their toes to create attractive opportunities as new situations unfold. Let’s review Anworth’s latest disclosures and see whether its management was able to create opportunities during the quarter.
Earnings highlights
First, let’s go over some dry figures and later try to interpret them given the prevailing environment.
Is it actually an outperformance?
Anworth Mortgage Asset Corporation (NYSE:ANH) started with a top line that was higher than the prior quarter’s and ended with a bottom line that lagged behind. Could this actually be called a solid quarter and an outperformance? I don’t think so!
To explain my answer, I will have to go over the company’s portfolio composition. During the first quarter, fixed-rate Agency securities were 21% of the company’s entire portfolio. That proportion remained the same during the second quarter as well. The rest are adjustable-rate securities, similar to the ones Capstead Mortgage Corporation (NYSE:CMO) owns. Given that rates are on the rise, management should have gotten rid of some of exposure in 30-year fixed-rate securities, just like American Capital Agency Corp. (NASDAQ:AGNC) did. The 30-year fixed-rate security is more sensitive to changes in interest rates, making the book value more vulnerable.
Another reason that I think this was not an actual outperformance is because the company did not control its operating expenses very well during the quarter. Expenses surged 4% to $4.06 million. It was obvious that the rising interest rates would bring down mortgage-backed security prices, causing the bottom line to get little support from gains on sales. Gains on sales of Agency mortgage-backed securities plunged 60%. Given the expected lack of support from gains on sales of securities, the management should have focused more on expense control.
While no one can control external factors such as interest rates and prepayments, the management at other mREITs took some measures to ensure minimum book value erosion. At Anworth Mortgage Asset Corporation (NYSE:ANH), however, the management was not even able to control expenses well. I believe that internal activism could have capped book value erosion at Anworth.
Peers analysis
Let’s see how American Capital Agency Corp. (NASDAQ:AGNC) and Capstead Mortgage Corporation (NYSE:CMO) did during the second quarter for comparison.
There were significant signs of internal activism at American Capital Agency Corp. (NASDAQ:AGNC) during the quarter. The management got rid of some of its 30-year fixed-rate securities in order to provide some cushion against book value erosion. Management also decided to actively manage its assets and hedges to create attractive opportunities. This capped the company’s book value erosion at 11.8%.
This is even better because American Capital Agency Corp. (NASDAQ:AGNC) is exclusively invested in the fixed-rate Agency paper whose price is more vulnerable to changes in interest rates. The future for American Capital is tough, particularly in the prevailing environment rising interest rates. The company needs to raise more capital in order to purchase new mortgage-backed securities with higher yields.
Now let’s look at Capstead Mortgage Corporation (NYSE:CMO), an Agency-only mREIT with exclusive investments in the adjustable-rate securities. These securities provide an automatic cushion to book value erosion in times of climbing interest rates and offer additional returns as the yields adjust to more current rates. As a result, the management at Capstead and other mREITs that have large exposures in adjustable-rate securities don’t need internal activism.
Because of the composition and structure of the asset portfolio, Capstead Mortgage Corporation (NYSE:CMO) reported a 5.9% sequential decline in its book value. The future for Capstead holds twin benefits, one in the shape of higher income and the other in providing a book value cushion. If rates continue to climb, the adjustable-rate mortgage-backed securities held by Capstead will adjust to more current rates and yield higher; this will cause income to increase. At the same time, they are less sensitive to changes in interest rates overall.
Conclusion
I believe that the current situation demands that the management teams at mREITs show some internal activism if they are to be considered solid investments. Even though Anworth Mortgage Asset Corporation (NYSE:ANH) beat its bottom line estimate, it was not an actual outperformance. Its management failed to rebalance its portfolio to better suit the environment. On the other hand, the management at American Capital Agency Corp. (NASDAQ:AGNC) remained active which is why it was able to cap book value erosion. Capstead Mortgage Corporation (NYSE:CMO) also presents an excellent investment opportunity even under rising interest rates because of its adjustable-rate securities.
The article Internal Activism will Help Anworth in the Future originally appeared on Fool.com and is written by Adnan Khan.
Adnan Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Adnan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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