“I’m pretty upset that CYS has gotten so upside down,” said Hoffman, adding that he tracks the stock daily to decide whether he’ll hold or sell his stake.
Mortgage REITs, which attracted retail investors like Hoffman with double-digit yields amid record-low interest rates, plunged 17% since May 14 as government-backed mortgage bonds endured the longest monthly losing streak since 1999. Amid the rout, the companies shifted to more defensive strategies, reducing the potential for future earnings that are used to pay dividends. Their actions proved to be premature after the U.S. central bank last month unexpectedly held off on slowing its $85 billion in monthly bond buying.
At least 10 of the firms cut third-quarter payouts, including Annaly Capital Management Inc., the largest, American Capital Agency Corp. and Apollo Residential Mortgage Inc. Retail investors, who make up a high percentage of mortgage REIT shareholders, could be more likely to sell after the reductions, said Christopher Donat, an analyst at New York-based Sandler O’Neill & Partners LP.
More than half of American Capital Agency owners are retail, according to Donat. For Armour Residential REIT Inc., which reduced its monthly dividend by 29% and has sold almost a quarter of its holdings since the end of June, the retail base is almost 70% and for CYS it’s more than a third.
“In the past few years there was this quest for yield among retail investors so they got more into newer agency mortgage REITs such as Armour and American Capital,” said Donat, who has a sell rating on the two companies’ shares. “If those investors start selling mortgage REITs, institutions might be worried there’s more retail selling to come and not take up the slack.”
Hoffman became more involved in investing during the past decade as the button manufacturing business his father started in 1939 shrunk. He was attracted to REITs including CYS and Annaly last year as the firms were paying dividends almost twice the average yield on company junk bonds.
Hoffman held Annaly for two month-long periods last year and bought CYS in September 2012 after the stock gained 71% in the previous three years, including reinvested dividends, outperforming a Bloomberg index of mortgage REITs that increased 63% in the same period.
The purchase came a week before the Fed started its latest round of buying home-loan securities and Treasuries to bring down borrowing costs. The central bank’s purchases also drove down yields on new bonds bought by mortgage REITs and increased homeowner refinancing, reducing their profits.
The shares took another hit in May when the Fed signaled it was weighing when to reduce purchases.
“Investors didn’t anticipate asset prices to weaken as quickly as they did,” said Daniel Furtado, an analyst at Jefferies Group LLC. “People were parked in these assets thinking the economy was still just trudging along.”
CYS, based in Waltham, Mass., and run by former Fidelity Investments bond manager Kevin Grant, last month maintained its quarterly dividend of 34%, for an annual yield of 17%. Still, investment bank JMP Securities LLC predicts a lower payout this quarter after the firm reduced its assets by 15% from May through June. Representatives from CYS didn’t respond to telephone messages seeking comment on the company’s strategy and payouts.
CYS’s dividend payments reduced Hoffman’s loss to 27% from 43% through Oct 2. Hoffman said he may sell the REIT if he can find another investment that pays a high yield.
“Before I make a move out of something I have to have something to put it into, and there isn’t much I find out there attractive in dividend land,” Hoffman said.
Annaly already dropped its quarterly payout 13% to $0.35 last month; American Capital reduced by its dividend by 24% to $0.80 and Apollo Residential by 43% to $0.40. Spokesmen for the companies declined to comment.
Some management teams were overly conservative and cut more than they needed to, according to Merrill Ross, an analyst with Baltimore-based Wunderlich Securities Inc.
“The dividends will be partly restored in the next year, not fully, that will take longer,” she said.
Mortgage REITs used several strategies to prepare for the Fed’s potential retreat, including reducing their use of borrowed money, increasing interest-rate hedges, shifting to shorter-term bonds and adding to cash reserves.
American Capital Agency shifted its portfolio toward 15-year mortgage securities from 30-year debt in the second quarter, president Gary Kain said on a conference call in July. It also reduced investments to limit the increase in its leverage to 8.5 times, from 8.1, as the falling value of its holdings eroded shareholder equity, he said. When markets stabilize, it could add more leverage, he said.
“Over time, this could be a very good environment but right now we’re sort of playing defense,” he said. The REIT has declined 10% this year including reinvested dividends.
Two Harbors Investment Corp., based in Minnetonka, Minn., added derivatives to protect it against rising interest rates. The cost of the hedges reduces earnings. The REIT, which cut its dividend by 9.7%, has returned 3.3% this year.
“When there’s a time of great volatility and high uncertainty, one of the key things to do in our mind is to protect book value,” chief investment officer Bill Roth said Sept. 10 at a conference. “Because our ability to pay dividends over the years to come is driven largely by how much capital we have and if our capital base is deteriorated or eroded, our ability to pay future dividends goes down.”
After the REITs prepared for a rise in rates, the rates fell. A Bloomberg index of yields on benchmark Fannie Mae 30-year securities dropped yesterday to 3.30%, after rising to 3.81% on Sept. 5 from 2.28% in May as speculation grew that the Fed would pare its debt purchases.