If you like stocks with the biggest dividend yields in the market, then you have to love real estate investment trusts that invest in mortgage securities. For years now, many mortgage real estate investment trusts have paid double-digit dividend yields while seeing some impressive price gains as well.
But for a while, skeptics have believed that eventually, good times for mortgage REITs would come to an end. Now, news from four of the most popular mortgage REITs has some wondering whether that end will come sooner than later.
The dreaded dividend cut
One fear that some, including my Foolish colleague Anand Chokkavelu, have expressed is that at some point, the extremely favorable conditions that have supported mortgage REIT profits will change. To understand the impact of such a trend change, let me take a break to give you some background on how these investments work.
Mortgage REITs make money by borrowing money, typically at rates based on prevailing short-term interest rates, and using it to buy mortgage-backed securities, whose income payments are generally based on longer-term interest rates. When the spread between short-term and long-term rates is wide, as it has been for some time, mortgage REITs are extremely profitable. When rate spreads tighten, however, profits get hurt. And since REITs pay the bulk of their income in dividends, lower profits mean smaller dividend payments.
That's apparently what happened to Annaly Capital (NYSE: NLY ) and Chimera Investment (NYSE: CIM ) this quarter. On Monday, Annaly announced that it was dropping its dividend to $0.62 per share, a reduction of 3% from the previous quarter and down from its high of $0.75 at the end of 2009. Similarly, Chimera also cut its dividend for the second quarter in a row, with a much bigger cut of 18% to $0.14 per share. Chimera shares dropped 4% on the news, while Annaly lost a more modest 1%.
Yet the conditions you'd expect to see in a falling-dividend environment for mortgage REITs don't seem to be present. Short-term rates haven't budged, and long-term rates spent much of the first quarter at higher levels before falling back near their end-of-2010 levels. Moreover, Cypress Sharpridge (NYSE: CYS ) announced earlier this month that it would hold its dividend steady for the first quarter. Because dividends are a leading indicator of quarterly income in this industry, we should know more when Annaly and Chimera make their next earnings report.
Gimme more shares
Meanwhile, some other mortgage REITs are cashing in on investor interest before it has a chance to evaporate. This week, both American Capital Agency (Nasdaq: AGNC ) and Invesco Mortgage Capital (NYSE: IVR ) announced massive secondary offerings, which sent their shares sharply downward. American Capital Agency offered 28 million new shares at a price of just under $28 per share to bring proceeds of $780 million, effectively increasing the size of the REIT by about 30%. Invesco's offering of 19 million shares pushed its share count up by nearly 40% and should raise around $400 million given current share prices. Again, shares of both companies fell 3% to 4% in response to the news.
Secondary offerings aren't new to the mortgage REIT industry, and they aren't automatically bad for investors. Both Hatteras Financial (NYSE: HTS ) and Two Harbors (NYSE: TWO ) have announced similar secondary offering during March. But typically, new shares are priced at a slight discount to the prevailing market price, which often causes the share price to drop.
The bigger concern, however, is an overheating market. Most of these companies plan to use their new capital to buy more mortgage securities. At some point, though, as the REITs compete against each other for the best securities, some of them will have to settle for lower-quality investments -- and eventually, that could come back to haunt them.
Don't turn that dial
As long as the Federal Reserve doesn't start hiking rates, mortgage REIT investors probably have some time before any major problems appear. But to make sure you don't miss any important news, you should start keeping a close watch on the mortgage REITs you're most interested in. That way, when you decide the long-anticipated end of the mortgage REIT bull market has finally come, you'll be able to get out quickly and keep your profits.