American Capital Agency Corp. (AGNC), Annaly Capital Management, Inc. (NLY): Are Highly-Leveraged mREITs the Next Target of a Witch Hunt?

The significant financial market downturn beginning in 2008 instilled a fear that has bred a constant vigil of heightened wariness. This feeling has caused many investment ideas to be targeted as the next source of market collapse.

One sector that has recently gained this stigma is a subset of real estate investment trusts (REIT) that invest in mortgage obligations (mREIT), using borrowed funds to acquire and control large pools of such concentrated obligations. Due to the REIT structure, these companies return at least 90% of net income to shareholders in the form of dividends. The use of leverage in this group has given very attractive returns on dividends alone.

The high current dividend yield of American Capital Agency Corp. (NASDAQ:AGNC) is enough to stop the average investor from looking further. Based on a price per share of $32.80, the $5.00 per share dividend is a whopping 15.24%. Take a look at the snapshot of financial highlights and pay close attention to the debt-to-equity ratio. The value list is 7.04, which indicates a significantly high level of debt.

American Capital Agency Corp. (NASDAQ:AGNC) generates its profits, charges management fees and passes the net income, which may be adjusted upwards by non-cash expenses, to shareholders. The portfolio is based entirely on mortgage obligations issued by the Federal National Mortgage Association, also known as Fannie Mae and once a NYSE listed stock, and Federal Home Loan Mortgage Corp, which has the nickname of Freddie Mac. These two corporate entities were the backbone of the mortgage industry and remain supported by the Federal Government.

American Capital Agency Corp. (NASDAQ:AGNC)’s model is based on buying seven times the size of obligations issued by these entities. They then manage the cash flows and risks associated with the use of current low short-term interest rates. The profits are based on the return of assets, less the cost of debt and the cost of management. What remains is distributed to shareholders, and using the high level of debt it is easy to see why such high dividends are returned.

While I believe that the prudent use of leverage to enhance returns is a viable strategy for a sophisticated investor that can afford the greater risk of loss of capital, the equity to debt ratio of American Capital Agency Corp. (NASDAQ:AGNC) offers no protection to the equity when a sharp rise in short term interest rates occurs. As a stand-alone investment, caveat emptor holds true.

The next extremely attractive dividend paying mREIT is Western Asset Mortgage Capital Corp (NYSE:WMC). The current share price of $22 and dividend of $3.80 per share gives a yield of 17.26%. Western Asset Mortgage Capital Corp (NYSE:WMC)purchases mortgages that are not guaranteed and, per the table below, is operating on a 9.16 debt-to-equity ratio.