U.S. Default Twist, Reward Overshadowed By Risk in Mortgage REITs (HTS, CMO, NLY, CIM, ANH, MFA, REM)

The world of Mortgage REITs offers massive yields for income investors.  There is a big caveat here.  It offers massive yields, until it doesn’t… then you don’t want to be around this sector.  Over the weekend came a report from Barron’s highlighting both Hatteras Financial Corporation (NYSE: HTS) and Capstead Mortgage Corporation (NYSE: CMO).  The benefit that Barron’s sees here is that these tend to be exposed to adjustable rate mortgages sponsored by the government-sponsored entities.  We have a whole host of concerns that were not really addressed.

Some of the more frequent mortgage REITs that we cover are as follows: Annaly Capital Management, Inc. (NYSE: NLY); Chimera Investment Corporation (NYSE: CIM); Anworth Mortgage Asset Corporation (NYSE: ANH); and MFA Financial, Inc. (NYSE: MFA).  ETF investors can look to the FTSE NAREIT All Mortgage Capped Index (NYSE: REM).  There is a reason we highlight this sector.  There are risks here in this sector even though Barron”s did warn that investors should not buy these for capital appreciation.  It believes that the yields are the juice here and also believes that ARM-related mortgage REITs could even see rising yields.

Investors always have to assume an “implied dividend” rather than a static dividend because REITs have to pay out 90% of their income for their tax structure.  It is the leverage that can boost this yield, but it is that same leverage which can act as a guillotine under the right (or wrong) circumstances.  Barron’s noted that the eventual rise in rates will hurt payouts in many but believes these are safe until around January 2013.  Barron’s did at least pick the cheaper REITS in the group at about 1.1-times book value.

Our concerns are much more pointed than those of Barron’s.  There are more risks that have started to come to light in the recent days and weeks that were not given much concern.  If something closer to a double-dip recession arises then these are going to suffer more P&I delinquencies and defaults.  While many or most mortgages held by these REITs are GSE-backed, there is now the risk that Uncle Sam might actually enter into a period of a temporary debt default.  That is why you saw the outlook go to “CreditWatch Negative” on Friday at S&P for the government, many GSEs, government dependent entities, and even insurance companies which are riddled with long-term government and agency debt securities.  Keep in mind that Egan Jones did formally downgrade the U.S. government over the weekend as a warning signal that US investors have to worry.

Hatteras Financial Corporation (NYSE: HTS) offers an implied dividend yield of about 14.1%.  The shares recently closed at $28.44 and the 52-week trading range is $27.12 to $31.98.  Capstead Mortgage Corporation (NYSE: CMO) offers an implied dividend yield of about 14.6%.  The shares recently closed at $13.16 and the 52-week trading range is $10.78 to $13.95.  The four mortgage REITs we routinely cover are as follows:

Annaly Capital Management, Inc. (NYSE: NLY) offers an implied dividend yield of about 14.5%.  The shares recently closed at $17.96 and the 52-week trading range is $16.73 to $18.79.

Chimera Investment Corporation (NYSE: CIM), often considered Annaly’s vulture vehicle, offers an implied dividend yield of about 16%.  The shares recently closed at $3.25 and the 52-week trading range is $3.18 to $4.36.  Its shares are down 4% today as the market woes continue and is down at $3.11.

Anworth Mortgage Asset Corporation (NYSE: ANH) has an implied dividend yield of about 13.8%.  The shares recently closed at $7.23.  The 52-week trading range is $5.74 to $7.52.

MFA Financial, Inc. (NYSE: MFA) offers an implied dividend yield of close to 12.8%.  The shares recently closed at $7.79 and the 52-week trading range is $7.10 to $8.64.

We are taking a more cautious stance than Barron’s is willing to take, even if they are focusing on Mortgage REITs tied closer to ARMs than to traditional mortgage products.  The politics in Washington can often bring havoc where there should be at least some harmony.  That is the case today.

Another alternative is the FTSE NAREIT All Mortgage Capped Index (NYSE: REM), but it tends to offer a lower implied yield with equally sporadic payout fluctuations.  It is less liquid than many other REIT ETFs and is less liquid than many of its components. The fund invests in securities of the index and in depositary receipts representing securities of the index.  After recently closing at $14.65, the 52-week trading range is $13.98 to $16.07.

After taking a look at this, it might seem like you are seeing a “Sell” rating.  That is not really the case.  If the politicians will stop gambling the entire U.S. credit ratings for political gains and for political ambitions, many of our fears normalize.  Our fears will normalize for this year, but not into early 2013 as Barron’s suggested.

JON C. OGG