Mortgage REITs have long been retail investors’ favorite for their elevated dividend yields. However, before chasing these elevated yields, you should be certain about two things. One, the shareholder distribution is sustainable in the future. Two, any future capital depreciation does not offset the dividend yield. So, in short, investors must look for total returns as an appropriate measure to gauge an investment opportunity. This article features three mortgage REITs that I believe have the potential to provide sustained total returns in the near future.
Capstead Mortgage Corporation (NYSE:CMO) is one such mREIT that has the potential to offer sustained dividends, coupled with capital appreciation over the coming quarters. One of the major reasons for this outperformance is the nature and design of its asset portfolio.
The company’s charter allows it to invest exclusively in the adjustable-rate Agency residential mortgage backed securities. Given the prevailing rising rates environment, these securities provide twin benefits of higher earnings potential and protection against book value erosion.
The adjustable-rate mortgage backed securities adjust their periodical payments to more current rates on the upcoming reset date. Because their payments are based on the prevailing rates, their prices don’t fluctuate as much, compared to the prices of fixed-rate securities. Therefore, they tend to provide some book value protection. On the other hand, since their payments are adjusted to more current rates, they tend to offer higher yields under the current rising rates environment. While the earnings potential is enhanced over the longer-term, book value protection happens immediately.
A look at the second quarter results also proves my point. During the second quarter, Capstead Mortgage Corporation (NYSE:CMO)’s book value plunged only 5.6% over the first quarter. This is one of the lowest book value declines for an Agency-only mREIT this quarter. Also, during the second quarter, Capstead Mortgage Corporation (NYSE:CMO) reported a 15 basis point decline in its net interest rate spread. The net interest rate spread is a key earnings matrix for mREITs. The decline in the second quarter spread is also one of the lowest compared to its peers.
The company offers a dividend yield of 10.3% on its quarterly shareholder distribution of $0.31 per share. The past four quarters’ cash dividend coverage ratio leads me to believe that this quarterly shareholder distribution is fairly sustainable. The company has an average cash dividend coverage ratio of 1.65 times, which means it has been able to generate 1.65 times higher operating cash flows than the quarterly dividend payments. The stock is currently trading at $12.01 per share, while analysts have a consensus mean target of $13.15 per share. This gives upside potential of 9.5% and a total return of nearly 20%.
American Capital Agency Corp. (NASDAQ:AGNC) is another Agency-only mREIT I am bullish on. The company’s charter allows it to invest exclusively in fixed-rate Agency residential mortgage backed securities. It is one of the very few well managed mREITs in the industry.
The company has shown its resolve to get rid of some of the long-term (30-year) fixed rate Agency MBS and add more 15-year MBS. The 15-year MBS make up around 40% of its entire asset portfolio. The price of the 30-year MBS has the highest sensitively to changes in interest rates. Therefore, its abundance causes significant book value declines. The 15-year MBS has less price sensitivity to changes in interest rates. So, the management’s resolve will preserve the book value against further declines.
Now, how does it ensure higher earnings potential? The reduction in the 30-year MBS will lead to lower earnings, so to offset this, the management has decided to actively manage its assets and hedges to capture and create attractive investment opportunities when they present themselves. So, with higher earnings potential and book value protection, American Capital Agency Corp. (NASDAQ:AGNC) is all set for a bright future.