Mortgage agency REITs have been badly hammered in the past three months. For the hardy breed of investors who can withstand the stomach-churning volatility, the rewards can be huge indeed. REITs in general carry some of the highest dividend yields in the market.

American Capital Agency (AGNC 0.21%) (AGNC 0.21%) (AGNC 0.21%) is an mREIT that invests exclusively in agency-backed mortgage securities. This mREIT sports an impressive 18.5% dividend yield. American Capital Agency finances its investments primarily through short-term borrowings. This makes the firm vulnerable to interest rate fluctuations. Whenever short-term rates rise faster than long-term rates, mREITs suffer from squeezed earnings.

It is this fear that has sent American Capital's stock tumbling from its April 26, 2013, $33 price to the current $22 trading range, in a short span of just five months.

American Capital Agency has not been alone in the recent drubbing. Annaly Capital Management (NLY 0.21%) (NLY 0.21%) (NLY 0.21%), CYS Investments (NYSE: CYS), and ARMOUR Residential (ARR -1.67%) have all fared poorly during the summer months.

What's happening to agency trusts? 
While all players have been hurt recently, agency-focused trusts such as American Capital Agency were the clear losers. There were a few things in the mix that worked in tandem to add to the mREIT's growing pains. One of these is the 10-year Treasury yield, which hit 2.90% recently, very close to the two-year high.

Another reason is most investors expected the Fed to start cutting down on its $85 billion-a-month asset purchase program that is part of its stimulus package. Investors were spot-on this one since the Federal Open Market Committee released the minutes for its July meeting last week that revealed it was comfortable with a tapering timeline. Although it failed to issue a definitive timeline of when the monetary tightening would commence.

The tapering timeline case is further exacerbated by the growing fears that Larry Summers is the hot favorite to replace the Fed's chairman Ben Bernanke, reportedly trouncing his rival and other thought-to-be contender Janet Yellen. Mr. Summers is seen as a strong proponent of the Fed cuts and could likely speed up the process. Many investors would have preferred Yellen, since she comes across as being more moderate on the cuts.

American Capital Agency MBS portfolio still weak 
In a bid to hedge against interest rate fluctuations and preserve book value over the short-term, American Capital Agency has been employing a business strategy that favors acquiring or holding fewer price-sensitive mortgage-backed securities, or MBS, which in turn generate lower yields. As a result, the firm has been increasing its 15-year MBS holdings while offloading its 30-year MBS holdings. Fifteen-year MBS carry a lower volatility than their 30-year counterparts. On the flip side, these investment vehicles generate lower yields.

Although this strategy will help the company insulate its investments from substantive unrealized losses, in case the U.S. Treasury yields and mortgage rates continue increasing at a modest or rapid pace, the lower-yield 15-year MBS is likely to negatively impact its cash interest income.

American Capital Agency reported an enormous $2.8 billion MBS valuation loss in the second quarter. The firm had earlier projected a $1.3 billion valuation loss on its MBS portfolio in the first week of the current quarter (third quarter). The valuation loss reversed course in the following week and had, in fact, netted itself out by July 19, 2013.

From around mid-July to mid-August, cumulative quarterly 15-year and 30-year MBS price valuations had been ranging from slightly negative in the MBS coupon spectrum's lower end to slightly positive in its higher end. From the way the firm's MBS portfolio has panned out thus far, American Capital Agency's MBS portfolio could likely book a $1 billion-plus valuation loss in the first half of the third quarter.

Bottom line
The Fed's announcement that it was comfortable with a tapering timeline will not help ease matters for mREITs such as American Capital Agency, although the firm's derivatives will help offset some of the MBS losses. Although the firm reported an industry-high 18.9% dividend yield in the second quarter, the overall outlook for the remaining weeks of the third quarter is not good.

Maybe American Capital Agency should learn from CYS, whose hedging experience proved to be a nightmare in the second quarter. CYS still manages to record a respectable 17.5% dividend despite the setback. ARMOUR Residential, with monthly dividend payouts, could be among the first to announce cuts. But all is not lost. Annaly Capital was a victim of paying out piddling dividends in 2005 when its dividend dipped to just $0.10, yet the firm survived and is still one of the most-respected mREITs in the market. Of course, such low dividends can sound the death knell for an mREIT.

Annaly sports a near-14% annualized dividend yield, which is considerably lower than American Capital Agency. Its vast experience; however, may make it a better long-term investment for those looking for capital appreciation.