How do agency REITs pay such high dividends investing in securities that don’t pay much?
Mortgage REITs like Annaly (NLY), American Capital Agency (AGNC), MFA Financial (MFA), Capstead (CMO), and Hatteras (HTS) tend to have high dividend yields, yet agency mortgage-backed securities don’t pay low-double-digit returns. To achieve these sorts of returns, REITs—particularly agency REITs—employ leverage. In other words, they’ll borrow many times their equity in order to provide these high sorts of returns. The use of leverage is a double-edged sword. Even though agency mortgage-backed securities bear no credit risk (since principal and interest payments are guaranteed by the government), they do have a lot of interest rate risk, and leverage magnifies this risk.
The typical mortgage REIT balance sheet
On the asset side of the balance sheet, REITs hold mortgage-backed securities and other assets that pay interest. On the liability side, they use many different techniques to finance their balance sheet. By far, the most popular is the repurchase agreement, which is basically a secured loan. The REIT will pledge the assets as collateral (though, mechanically, they sell them at a discount and agree to buy them back at a fixed price). Of course, this creates a maturity mismatch, which they will hedge with interest rate derivatives—typically swaps and “swaptions.” This hedging will reduce returns, but it allows the REIT to operate with more leverage.
The anticipated end of QE slammed the REITs
When the Fed hinted at tapering at the June 2013 FOMC meeting, rates began to rise and REITs were clobbered. The hardest-hit were agency REITs. Since agency REITs invest in MBS (mortgage-backed securities) with no credit risk, the nominal returns are quite low. To generate a decent return, they employ a lot of leverage and were caught once rates started going up. They were forced to de-leverage in a difficult interest rate environment. In fact, Annaly cut its leverage ratio from 6.5x to 5x. While there are other risks that agency REITs face (like funding risk or counterparty risk), their biggest is interest rate risk. As it looks like rates have stabilized, Annaly has been increasing its leverage ratio again. This is more or less a bet that the yield curve isn’t going to steepen markedly in the near future. Note that American Capital Agency (AGNC) is leaning the same way. The silver lining from the end of QE is that interest rate spreads are a lot higher than they were a year ago.