With eye-popping 10% dividend yields, mortgage real estate investment trusts, or mREITs, like Annaly Capital Management (NYSE: NLY), American Capital Agency (NASDAQ: AGNC), and ARMOUR Residential REIT (NYSE: ARR) offer a tempting proposition. However, because these companies have a more volatile history ups and downs, they could prove dangerous for retirees working with a shorter investing horizon.
There are number of reasons for this rocky history, but I am going to focus on one important aspect of the mREIT business model that leaves these companies vulnerable to interest rates.
What causes the ups and downs?
As finance companies, mREITs share some similarities with traditional banks. For instance, banks collect customer deposits and then use that money to make loans. In a similar fashion, mREITs borrow money and then buy mortgage-backed securities – or, pools of residential mortgages packaged into fixed-income securities. In both cases the companies are earning the spread, or difference, between what it costs to borrow and the yield on assets.
The big advantage for banks, however, is that customer deposits represent a reliable source of low-cost funding, which not available to mREITs. Instead, mREITs use repurchase agreements, or REPO loans, which allows them to use collateral to make short-term borrowings based on market rates.
Ultimately, mREITs have two big variables: The yield on the securities they buy, and the interest rate they pay to borrow. Most important, these rates do not always move in unison; rather, they will spread apart and narrow over time. The chart below show the difference in yield between the 10 and two-year treasury rate, which has traditionally matched up well with the spread mREITs earn.
As you can see above, when the spread is nice and wide, like 2010, Annaly and its peers can borrow cheaply and earn a higher yield on their securities. However, when the opposite is true, like in 2007, this is when investors start to see dramatically falling stock prices and dividend cuts.
Prove it!
But you certain don’t have to take my word for it. The chart below looks a little like a three year old's art project, but it is the same chart from above just with Annaly’s dividend and stock price per share laid on top of it.
What you see above is that as spreads widen out, like from 2008 to 2010, Annaly’s is able to generate better returns, and we see their dividend and stock price rise. The concern is that as these spreads tighten, like from 2005 to 2007, we see some pretty dramatic drops in stock price and dividends. Moreover, the chart only shows Annaly, but the ARMOUR Residential and American Capital Agency are investing in the same assets with a similar method, so the results tend to follow closely.
Why will this continue?
There is an old saying about past results not predicting the future, but I think there is good reason to believe this will continue to happen -- and to prove it I'll have to break out one more chart.
Logically, 10-year treasury bonds should always yield more than two-year bonds, but a quick glance at 2001 and 2007 in the chart above and you can see that isn't always the case. The reason something like this can happen for this is because long and short-term rates are controlled by difference forces with different goals.
For instance, short-term rates are more or less controlled by the U.S. Federal Reserve. In fact, this is something we are seeing play out right now as the Fed lowered rates to stimulate the economy following the financial crisis in 2009, and is now working towards an increase. On the other hand, longer-term rates are market driven -- or, more heavily influenced by supply and demand. The end result is the Fed looking out for the economy, and investors looking out for themselves, which can create some interesting results.
So, over time, long and short-term interest rates will come together and spread apart and this will, at times, make life challenging for mREIT as well as create opportunity. The good news for mREITs is that interest rates tend to work themselves out over time. However, in shorter stints the mREIT business model is vulnerable to fairly dramatic price declines, and for retired investors looking for a smoother ride, or have a shorter-term investing horizon, you may want to avoid these investments.
