(05/15/14) Preferred Picks in Mortgage REITs

Mortgage REITs have had a tough time in the past 18 months, but we believe the worst is over and that now is the time to buy, suggests Marvin Appel, editor of Systems and Forecasts.

First, quantitative easing accelerated the rate at which earlier mortgages were refinanced. Then, the rise in interest rates reduced the value of these REITs' holdings.

As a result, major mortgage REITs such as American Capital Agency (AGNC), Hatteras Financial (HTS), and Annaly Capital Management (NLY) lost 18%-20% in total return from September 2012 until now.

It appears that the first quarter of 2014 saw an end to this losing streak, creating renewed opportunity in this area. First, both of these companies saw their book value per share grow during the first quarter.

Also, net interest income was sufficient to cover the quarterly dividends, which is an improvement over 2013 when these companies significantly reduced their payouts.

Moreover, I do not project big interest rate volatility for the rest of 2014. Fed tapering over the rest of the year is already factored into expectations, and the Fed has made it clear that it will not raise its short-term interest rate target this year. That makes HTS and AGNC attractive (but risky) investments for the rest of 2014.

Hatteras had particular difficulty last year because of its emphasis on floating rate mortgage-backed securities, which lost more value than fixed-rate mortgage securities in 2013.

However, looking ahead, Hatteras should be better protected when the Federal Reserve begins to raise short-term rates. The median maturity of its mortgage holdings (the length of time before the rates start to float) is 48 months.

I have long been a fan of the preferred stocks from American Capital Agency Preferred (AGNCP) and Hatteras Financial Preferred A (HTS-PA) because of their greater safety compared to the underlying common stocks.

Net interest income would have to be virtually wiped out, eliminating all common dividends, before impinging on preferred dividends. Because of the greater safety, the preferreds yield less. However, both are attractive income investments, with yields exceeding what is available in most other places.

Note that since these REITs do not pay corporate income taxes, their preferred dividends are taxed the same as bond interest (ordinary income) rather than the more advantageous federal tax rate that applies to preferred stocks from C-corporations that pay qualified dividends.