Focus of Article:
The focus of this article is to examine why such a large cash/stock dividend of $2.35 per share was declared by Western Asset Mortgage Capital Corp. (WMC) for the fourth quarter of 2013. This article will also compare WMC to two other mortgage real estate investment trust (mREIT) companies within the sector to show why WMC is overvalued. The two comparable mREIT companies will be American Capital Agency Corp. (AGNC) and American Capital Mortgage Investment Corp. (MTGE).
This analysis will compare and contrast AGNC, MTGE, and WMC regarding the following topics: 1) mortgage-back security ("MBS") portfolio; 2) derivative portfolio; 3) taxation considerations and strategies; 4) current (discount) premium to BV; and 5) current annual dividend forward yield. Several supporting tables will be presented within this article to assist in understanding and examining the topics laid out above. This article will help readers gain a better perspective in regards to the similarities and differences between these three companies and understand some future pitfalls for WMC because they declared such a large dividend for the fourth quarter of 2013.
I am writing this particular article due to the recent requests that such an analysis be performed in light of the recent surprising dividend declaration by WMC. Understanding the characteristics of each company's MBS and derivative portfolios, taxation strategies and interpretations, current dividend yields, and current (discount) premium to BV can shed some light on which companies are undervalued or overvalued.
1) MBS Portfolio:
Let us start this analysis by comparing and contrasting what AGNC, MTGE, and WMC held within each company's MBS portfolio as of 9/30/2013. This would be a good account to start with in determining why WMC declared such a large dividend in the fourth quarter of 2013 when compared to AGNC and MTGE. Was WMC's MBS portfolio vastly different when compared to AGNC and MTGE and thus help explain the difference in dividend declarations for the fourth quarter of 2013?
Side Note: It should be noted AGNC is considered to be an "agency" mREIT. An agency mREIT has 100% of its MBS holdings backed by government-sponsored entities ("GSE") or a U.S. government agency. In contrast, both MTGE and WMC are considered to be a "hybrid" mREIT. A hybrid mREIT has both agency and non-agency MBS holdings. As of 9/30/2013, 97% of AGNC's portfolio, 85% of MTGE's portfolio, and 84% of WMC's portfolio consisted of fixed-rate agency MBS holdings. As such, it has been determined each company currently has a majority of its investments in fixed-rate agency MBS holdings. Therefore, I feel a comparison of these three companies is deemed appropriate (subtle differences will be quantified and discussed below).
To compare and contrast each company's fixed-rate agency MBS portfolio as of 9/30/2013, Table 1 is presented below.
Table 1 - Fixed-Rate Agency MBS Portfolio Comparison as of 9/30/2013 (AGNC vs. MTGE vs. WMC)
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Using Table 1 above as a reference, we see each company's fixed-rate agency MBS portfolio as of 9/30/2013. Table 1 breaks out each company's fixed-rate agency MBS portfolio by maturity (15, 20, 30-year) and coupon rate (2.5% - 6%). AGNC had 53% of the company's fixed-rate agency MBS portfolio in 15-year maturities, 2% in 20-year maturities, and 45% in 30-year maturities. Compared to the past few quarters, AGNC has continued to realign the company's MBS portfolio into the less price sensitive 15-year fixed-rate holdings as interest rates have risen. This strategy helps mitigate MBS valuation losses (hence BV losses) in a rising interest rate environment. MTGE also had this same strategy, however, slightly behind AGNC's proactive realignment. As of 9/30/2013, MTGE had 40% of the company's fixed-rate agency MBS portfolio in 15-year maturities, 2% in 20-year maturities, and 57% in 30-year maturities. In contrast, as of 9/30/2013 WMC had 0% of the company's fixed-rate agency MBS portfolio in 15-year maturities, 23% in 20-year maturities, and 77% in 30-year maturities. In a rising interest rate environment, WMC would suffer worse BV erosion when solely looking at each company's MBS portfolio. Since rates have increased (on a net basis) during the fourth quarter of 2013, WMC's fixed-rate agency portfolio is the most susceptible to fair market value ("FMV") (also known as "mark-to-market") MBS price declines. This assumption is solely based on each company's fixed-rate agency MBS portfolio and excludes the notion of net derivative valuation gains which will be addressed in the next topic.
Since we have determined WMC had a majority of its fixed-rate agency MBS portfolio as of 9/30/2013 in 30-year maturities, one would assume WMC had a modestly higher weighted average coupon ("WAC") rate when compared to AGNC and MTGE. However, as Table 1 indicates, this was not the case. WMC's WAC for the company's fixed-rate MBS portfolio was 3.56% as of 9/30/2013. In comparison, as of 9/30/2013 MTGE and AGNC had a WAC of 3.50% and 3.52%, respectively [net of "to-be-announced" ("TBA") MBS]. When calculated, WMC only had a WAC advantage of 6 and 4 percentage points when compared to MTGE and AGNC, respectively. The WAC results were somewhat surprising based on the fact 77% of WMC's fixed-rate agency MBS portfolio was in 30-year maturities (which tend to have higher coupons). As stated earlier, MTGE and AGNC only had fixed-rate agency MBS holdings with 30-year maturities of 57% and 45%, respectively. This was a modest to material proportional difference.
These two factors, WMC's higher proportion of 30-year fixed-rate agency MBS but basically the same WAC, lead me to believe WMC should have dividend distributions that are equal to (or at the most slightly above) what AGNC and MTGE have distributed over the past few quarters (generally speaking). However, WMC's cash/stock dividend of $2.35 per share for the fourth quarter of 2013 seems to be highly irregular not only when compared to AGNC and MTGE, but for the entire mREIT sector. Therefore, further evidence must be found to explain why such a dividend was declared. It's clearly not because of each company's MBS portfolio because they are fairly similar.
Since we have discussed each company's fixed-rate agency MBS portfolio, let us briefly highlight each company's variable-rate agency and non-agency MBS portfolios as of 9/30/2013.
Table 2 - Variable-Rate Agency and Non-Agency MBS Portfolios Comparison as of 9/30/2013 (AGNC vs. MTGE vs. WMC)
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Using Table 2 above as a reference, we see each company's variable-rate agency and non-agency MBS portfolio as of 9/30/2013. AGNC had $0.4 billion or 0.5% of the company's total MBS portfolio in agency interest-only ("IO") strips, $1.2 billion or 1.5% in agency collateralized mortgage obligations ("CMO") ($1.2 billion), and $1.0 billion or 1.2% in agency hybrid adjustable rate mortgages ("ARM"). In comparison, MTGE had $0.4 billion or 5.3% of the company's total MBS portfolio in variable-rate agency holdings and $0.9 billion or 11.0% in non-agency holdings (broken out between prime, subprime, alt-a, and option ARM securities). WMC had $0.3 billion or 8.5% of the company's total MBS portfolio in agency IO strips and agency commercial MBS ("CMBS") and $0.3 billion or 7.7% in non-agency holdings (broken out between non-agency RMBS and CMBS).
As such, there were some compositional and proportional differences when it came to each company's variable-rate agency and non-agency MBS portfolios. However, these subtle minor differences would not account for the vast difference in dividend declarations between WMC and both AGNC and MTGE during the fourth quarter of 2013. If anything, a look at each company's entire MBS portfolio shows each company is more similar than it would initially appear based on the recent dividend declarations. Therefore, additional considerations and accounts need to be analyzed. Let us now take a look at each company's derivative instruments to see what material differences (if any) arise within this particular portfolio.
2) Derivative Portfolio:
Let us now compare and contrast what AGNC, MTGE, and WMC held within each company's derivative portfolio as of 9/30/2013. Since we have concluded that each company's MBS portfolio was pretty similar, I would expect each company's derivative portfolio to be pretty similar as well regarding derivative instruments and hedging coverage ratios. To compare and contrast each company's derivative portfolio as of 9/30/2013, Table 3 is presented below.
Table 3 - Derivative Portfolio Comparison as of 9/30/2013 (AGNC vs. MTGE vs. WMC)
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Using Table 3 above as a reference, we see each company had a pretty similar hedging coverage ratio as of 9/30/0213. AGNC had a hedging coverage ratio of 93%. When compared to 6/30/2013, AGNC decreased the company's hedging coverage ratio by (9%). In comparison, as of 9/30/2013 MTGE had a hedging coverage ratio of only 77%. When compared to 6/30/2013, MTGE decreased the company's hedging coverage ratio by (25%). As the percentages indicate, as of 9/30/2013 MTGE had a less hedged MBS portfolio when compared to AGNC. The determination that MTGE had a lower hedging coverage ratio as of 9/30/2013 was partially offset by the fact the company's derivative portfolio had a weighted average duration was (5.7) years versus AGNC's (3.6) years. This makes sense because MTGE had the greater proportion of 30-year fixed-rate MBS when compared to AGNC.
In comparison, WMC only had interest rate swaps within the company's derivative portfolio as of 9/30/2013 (when excluding any IO strips deemed to be used as a derivative instrument). As such, WMC did not have any interest rate swaptions as part of the company's derivative portfolio as of 9/30/2013. Even so, WMC had a hedging coverage ratio of 91% as of 9/30/2013. WMC's hedging coverage ratio was slightly less when compared to AGNC but modestly higher when compared to MTGE. As anticipated, WMC's derivative portfolio had a weighted average duration was (7.4) years. This was much higher than AGNC's (3.6) years and modestly higher than MTGE's (5.7) years. As determined earlier, since WMC had 77% of the company's fixed-rate agency MBS portfolio in 30-year maturities, the higher weighted average duration makes sense.
As was the case with each company's MBS portfolio, there were some compositional and proportional differences when it came to each company's derivative portfolio. However, when taking a step back and looking at each company's hedging coverage ratio and weighted average duration, each portfolio was aligned extremely similar. As such, these minor compositional and proportional differences would not account for the vast difference in dividend declarations between WMC and both AGNC and MTGE during the fourth quarter of 2013. If anything, a look at each company's derivative portfolio shows each company is more similar than it would initially appear based on the recent dividend declarations. Therefore, additional considerations and accounts need to be analyzed. Where I believe this analysis really makes some headway is each company's taxation strategies and interpretations.
3) Taxation Strategies and Interpretations
I feel the best way to navigate through this topic is to take a few quotes from WMC's recent press release and center the company's taxation strategies and interpretations around these quotes. After a particular quote, I will state my thoughts about how WMC's taxation strategies and interpretations compare to AGNC and MTGE.
a) Taxation Strategies Regarding Internal Revenue Code ("IRC") REIT Provisions
The following is a quote from WMC's recent press release regarding the $2.35 per share dividend declaration for the fourth quarter of 2013:
"…The stock portion of the dividend is being paid by the Company in order for the Company to reduce its undistributed taxable income from 2013 and satisfy the REIT distribution requirements…"
From the quoted text above, WMC's management was basically stating the company had cumulative undistributed taxable income ("UTI") for its business operations in 2013. As such, the stock portion of the dividend reduces this cumulative UTI balance by a material portion.
To fully understand management's strategy regarding the company's "REIT distribution requirements", let us take a step back and understand one important REIT tax provision per the IRC. Under "Subchapter M" of the IRC, a company is qualified to be taxed as a REIT entity as long as the company passes certain tests and provisions. There are numerous REIT provisions that a company must adhere by to maintain its qualified REIT status for taxation purposes. For this article, we will focus on one specific provision.
A qualified REIT entity is required to distribute at least 90% of the company's annual REIT taxable income ("AREITTI") in a given calendar tax year in order to maintain its qualified REIT status (allows for the exclusion of net capital gains). A qualified REIT entity will not be subject to any federal or state corporate taxes if the company distributes all (100%) of its AREITTI to shareholders. If a company were to fail in distributing 90% of its AREITTI, it would lose its qualified REIT status under Subchapter M of the IRC for four years. If declassified, a company would have to pay corporate level taxes on the company's AREITTI. This would occur because a "dividends paid deduction" would be denied at the entity level under Section 561/562 of the IRC. Therefore, a company's management team should deem this specific provision extremely important. It seems WMC's management team was aware of such a provision and declared the additional stock dividend to satisfy the 90% AREITTI distribution requirement. However, an additional clause to this provision should be addressed.
In determining if a company is in compliance with the 90% AREITTI distribution requirement, a qualified REIT entity is allowed to treat dividends declared by September 15th and paid by December 31st of a given year as having been a distribution of its AREITTI from the PRIOR tax year. This is referred to as the "paid-in-arrears"/"spill-back" clause. This is an extremely important concept to understand.
From the quoted text earlier, WMC's management declared a special cash/stock dividend of $1.55 per share which was on top of the cash dividend of $0.80 per share. Again, this additional dividend was to distribute WMC's cumulative UTI built up during 2013. HOWEVER, the company really has until 9/15/2014 to declare (and 12/15/2014 to distribute) AREITTI generated during the 2013 calendar tax year. Even though the paid-in-arrears/spill-back clause is only voluntary, WMC COULD have retained this additional stock dividend of $1.55 per share and distributed this amount during the company's first, second, and possibly even third quarters of 2014. Again, under the paid-in-arrears/spillback clause, all dividend distributions declared prior to 9/15/2014 can be in relation to the company's AREITTI generated in 2013. Both AGNC and MTGE have used the paid-in-arrears/spillback clause in years past.
I'm not saying the paid-in-arrears/spillback clause is mandatory. However, WMC has basically distributed the company's remaining cumulative UTI out during the fourth quarter of 2013. As such, the probability of future dividend cuts greatly increases. Investors should be aware as such.
b) Taxation Interpretations of Derivative Net Realized Gains
Another topic I feel should be discussed is WMC's tax treatment of certain derivative net realized gains. The following is another quote from WMC's recent press release regarding the $2.35 per share dividend declaration for the fourth quarter of 2013:
"…Such incremental undistributed taxable income primarily pertains to net gains realized on certain hedging transactions and the inability to offset such gains for federal income tax purposes with net capital losses realized on the sale of mortgage-backed securities…"
From the quoted text above, one assertion WMC's management made was derivative net realized gains cannot be offset against net capital losses pertaining to MBS sales. As I have mentioned in previous articles regarding this topic, AGNC and MTGE came to this conclusion as well. Net capital losses on MBS sales are separated from derivative net realized gains; they cannot offset each other. MBS assets are considered "capital" assets per the IRC while derivative assets are considered "straddles" (generally speaking).
However, where WMC and AGNC/MTGE differ regarding taxation interpretations is the timing of when to account for derivative net realized gains. Through the first three quarters of 2013, WMC had a net realized gain regarding the company's interest rate swaps of $65.3 million. WMC also had a realized net valuation gain regarding the company's interest rate swaptions of $23.7 million. These interest rate swap/swaption net realized gains were partially offset by the following net realized losses: 1) ($0.1) million pertaining to agency and non-agency IO strips accounted for as derivative instruments; 2) ($0.9) million pertaining to put and call options; and 3) ($1.5) million pertaining to TBA MBS. When calculated, WMC has accumulated a net derivative valuation gain of approximately $86.4 million during the first three quarters of 2013.
From the quoted text earlier, WMC had declared an additional stock dividend of $1.55 per share mainly on the notion of this derivative net valuation gain of $86.4 million. As such, WMC has immediately accounted for this derivative net realized gain and included this amount in 2013 AREITTI. However, AGNC and MTGE have an entirely different interpretation of the tax treatment regarding a company's derivative net realized gain.
Both AGNC and MTGE had similar interest rate swap/swaption net realized gains during 2013. Through the first three quarters of 2013, AGNC had recognized an estimated interest rate swaption net realized gain of $222 million. Per AGNC's tax interpretation, each separate interest rate swaption net realized gain needed to be deferred and recognized into AREITTI over the life of the underlying interest rate swap (as if AGNC had converted the swaption contract and kept the underlying swap until termination). As such, AGNC had reversed out the company's entire interest rate swaption net realized gain in the quarter of occurrence and deferred the gain over the life of the underlying swap. Therefore, this initially lowered AREITTI in the quarter of occurrence and will slightly increase AREITTI over the life of the underlying interest rate swap. Again, WMC had an entirely different interpretation of the tax treatment regarding a company's derivative net realized gain.
Through the first three quarters of 2013, MTGE had recognized an estimated interest rate swap net realized gain of $54 million and interest rate swaption net realized gain of $14 million. As was the case with AGNC, for tax purposes these interest rate swap/swaption net realized valuation gains were deferred in the quarter of occurrence and recognized into AREITTI over the remaining life of the particular swap/underlying swap (as if MTGE had kept the swap until termination/converted the swaption contract and kept the underlying swap until termination). As such, MTGE had reversed out the company's entire interest rate swap/swaption net realized gain in the quarter of occurrence and deferred the gain over the life of the swap/underlying swap. Therefore, this initially lowered AREITTI in the quarter of occurrence and will slightly increase AREITTI over the life of the swap/underlying interest rate swap. As was the case with AGNC, WMC had an entirely different interpretation of the tax treatment regarding a company's derivative net realized gain.
Either this will have a very negative impact on WMC's dividend if AGNC's and MTGE's tax interpretations prove to be correct or a very positive impact on AGNC's and MTGE's dividend if WMC's tax interpretations prove to be correct. I am not here to state which tax interpretation is right/wrong (that is up to each company's auditors and/or the IRS). However, this difference in tax interpretations is pretty interesting and readers should be aware as such.
If one is asking my professional OPINION, I would say AGNC and MTGE have correctly interpreted the taxation rules regarding derivative net valuation gains (deferment of gain vs. immediate recognition). Since WMC seems to be the "minority party" regarding "special" dividend declarations for the entire mREIT sector during the fourth quarter of 2013, I am further erring on the side of AGNC and MTGE. Furthermore, WMC has had prior revisions to the company's financial statements (as recently as last year). Prior corrections and revisions tend to be a negative sign when companies have varying opinions about certain accounting/taxation treatments (generally speaking).
Now that we have found out why WMC declared such a large dividend for the fourth quarter of 2013 (non-use of the paid-in-arrears/spillback provision and differing tax treatment of derivative net realized gains), let us see how AGNC, MTGE, and WMC compare regarding each company's current (discount) premium to BV and current dividend yield.
4) Current (Discount) Premium to BV Analysis
A current (discount) premium to BV analysis between AGNC, MTGE, and WMC is shown in Table 4 below. Table 4 shows each company's recent BV change per quarter and current (discount) premium to BV as of 12/20/2013.
Table 4 - Recent BV Per Share Change and Current (Discount) Premium to BV Analysis (As of 12/20/2013) (AGNC vs. MTGE vs. WMC)
(Click to enlarge)
Using Table 4 above as a reference, AGNC had a BV of $25.24 per share at the end of the third quarter of 2013. As of 12/20/2013, AGNC's stock price trades at $19.84 per share. When calculated, this shows AGNC's stock price is currently trading at a ($5.40) per share or (21.37%) discount to BV as of 9/30/2013. This is a material discount to BV. Even if one makes the argument CURRENT BV is down approximately (5%) in the fourth quarter of 2013, a (16.37%) discount to CURRENT BV is still a material discount.
In comparison, MTGE had a BV of $22.37 per share at the end of the third quarter of 2013. As of 12/20/2013, MTGE's stock price trades at $18.20 per share. When calculated, this shows MTGE's stock price is currently trading at a ($4.17) per share or (18.64%) discount to BV as of 9/30/2013. This is a material discount to BV. Even if one makes the argument CURRENT BV is down approximately (4%) in the fourth quarter of 2013, a (14.64%) discount to CURRENT BV is still a material discount.
In sharp contrast, WMC had a BV of $16.81 per share at the end of the third quarter of 2013. As of 12/20/2013, WMC's stock price trades at $16.98 per share. When calculated, this shows WMC's stock price is currently trading at a $0.17 per share or 1.01% PREMIUM to BV as of 9/30/2013. Compared to the rest of the agency and hybrid mREIT sector stocks I research (17 different companies in all), WMC currently has at the highest price to BV ratio. If one makes the argument CURRENT BV is down approximately (3%) in the fourth quarter of 2013, a 4.01% premium to CURRENT BV is a large premium when compared to the 17 mREIT stocks I research.
Therefore, I feel both AGNC and MTGE are trading at attractive discounts while WMC is trading at an excessively high premium. Finally, let us take a look at each company's recent quarterly dividend per share amounts and current annual dividend forward yield.
5) Current Annual Dividend Forward Yield Analysis
A current annual dividend forward yield analysis between AGNC, MTGE, and WMC is shown in Table 5 below. Table 5 shows each company's recent quarterly dividend per share amounts and current annual dividend forward yield as of 12/20/2013.
Table 5 - Recent Quarterly Dividend Per Share and Current Annual Dividend Forward Yield Analysis (AGNC vs. MTGE vs. WMC)
(Click to enlarge)
Using Table 5 above as a reference, AGNC has cut the company's dividend from $1.25 per share during the first quarter of 2012 to $0.65 per share for the fourth quarter of 2013. Going further back, AGNC has cut the company's quarterly dividend per share amount by (54%) when comparing the current dividend rate to the dividend distributed during the first quarter of 2011. For the same timeframe, the agency mREIT sector stocks that I research (7 stocks) have averaged a dividend cut of (50%). As such, AGNC is basically in line with its agency mREIT peers regarding dividend per share reductions over the past three years. From these recent reductions, AGNC has a current annual dividend forward yield of 13.09%. Again, this is basically in line with the current agency mREIT sector average of a forward yield of 12.53%. When AGNC's current annual dividend rate is compared to the company's BV per share as of 9/30/2013, the current dividend rate has an annual yield of 10.29%. Once again, this is basically in line with the current agency mREIT sector average of 9.81%. Therefore, AGNC's recent dividend reductions have put the company more in line with its specific sector and the forward yield has become safer regarding future dividend cuts.
In comparison, MTGE has cut the company's dividend from $0.90 per share during the first quarter of 2012 to $0.65 per share for the fourth quarter of 2013. MTGE has cut the company's quarterly dividend per share amount by (28%) when comparing the current dividend rate to the dividend distributed during the first quarter of 2012 (initial public offering ("IPO") was in 2011). Since the first quarter of 2011, the hybrid mREIT sector stocks that I research (10 stocks) have averaged a dividend cut of (14%). As such, MTGE has cut the company's dividend more than the hybrid mREIT peers that I research. This makes sense because MTGE always had a material proportion of the company's MBS portfolio in fixed-rate agency holdings. As stated above, the average agency mREIT dividend cut was (50%) for the same timeframe. From these recent reductions, MTGE has a current annual dividend forward yield of 14.29%. This is basically in line with the current hybrid mREIT sector average of a forward yield of 13.98%. When MTGE's current annual dividend rate is compared to the company's BV per share as of 9/30/2013, the current dividend rate has an annual yield of 11.62%. Once again, this is basically in line with the current hybrid mREIT sector average of 12.42%. Therefore, as was the case with AGNC, MTGE's recent dividend reductions have put the company more in line with its specific sector and the forward yield has become safer regarding future dividend cuts.
In sharp contrast, WMC has only cut the company's dividend from $0.85 per share during the third quarter of 2012 (first full quarter of operations) to $0.80 per share for the fourth quarter of 2013 (when excluding the additional $1.55 per share cash/stock dividend recently announced). WMC has cut the company's quarterly dividend per share amount by only (6%) when comparing the current dividend rate to the dividend distributed during the third quarter of 2012. As stated earlier, since the first quarter of 2011 the hybrid mREIT sector stocks that I research (10 stocks) have averaged a dividend cut of (14%). As such, WMC has cut the company's dividend less than the hybrid mREIT peers that I research. This makes some sense because WMC has a low cost of funds rate which enhances net interest income (to an extent). As such, the less than average dividend cut is partially accounted for in my mind. However, the low cost of funds rate does not account for the huge $1.55 per share additional dividend declared in the fourth quarter of 2013 (as we have established earlier in the article). Furthermore, the average agency mREIT dividend cut was (50%) for the same timeframe. WMC always had a majority of the company's MBS portfolio in agency fixed-rate holdings and one could make an argument the company is currently comparable to an agency mREIT. Eventually, this could "catch-up" to WMC via dividend cuts due to the fact the company's WAC is relatively low when compared to the type of securities held (30-year fixed-rate MBS). From the company's slight quarterly dividend cut to $0.80 per share (when excluding the special cash/stock dividend of $1.55 per share for the fourth quarter of 2013), WMC has a current annual dividend forward yield of 18.85%. This is currently the highest forward yield (by several percentage points) out of all the 17 agency and hybrid mREIT sector stocks that I research. When WMC's current annual dividend rate is compared to the company's BV per share as of 9/30/2013, the current dividend rate has an annual yield of 19.04%. Once again, this is currently the highest annual dividend yield based on BV per share as of 9/30/2013 (by several percentage points) out of all the 17 agency and hybrid mREIT sector stocks that I research. After the total dividend of $2.35 per share is accounted for (and the stock resets when the ex dividend date occurs), WMC's forward yield (based on the new reduced quarterly dividend of $0.80 per share) will calculate to nearly 22%. In my opinion, this will be highly unsustainable. Therefore, WMC's recent dividend reduction to $0.80 per share seems like it will be under a high level of stress going into 2014.
Conclusions Drawn:
This article has examined why such a large cash/stock dividend of $2.35 per share was declared by WMC for the fourth quarter of 2013. This article also compared WMC to two other mREIT companies within the sector, AGNC and MTGE, to try and find out why this large dividend was declared by just WMC and not the rest of the mREIT sector. This analysis compared and contrasted these three companies regarding the following metrics: 1) MBS portfolio; 2) derivative portfolio; 3) taxation considerations and strategies; 4) current (discount) premium to BV; and 5) current annual dividend forward yield.
This article provided evidence that AGNC, MTGE, and WMC had pretty similar MBS and derivative portfolios as of 9/30/2013. These similarities held true during the past few quarters as well. However, this article has also determined WMC's large dividend declaration in the fourth quarter of 2013 was based on the non-use of the IRC's paid-in-arrears/spillback clause. WMC had immediately paid out most of the company's cumulative UTI from 2013 via the special cash/stock dividend of $1.55 per share. However, under the IRC's paid-in-arrears/spillback clause, all dividend distributions declared prior to 9/15/2014 can be in relation to the company's AREITTI generated in 2013. Both AGNC and MTGE have used the IRC's paid-in-arrears/spillback clause in years past. This was one reason why WMC declared such a large dividend in the fourth quarter of 2013.
More importantly, another topic where WMC differs from both AGNC and MTGE is the company's tax treatment of certain derivative net realized gains. WMC has interpreted that a derivative net realized gain should be immediately recognized into AREITTI in the quarter/year of occurrence. As such, WMC's large derivative net realized gain during 2013 is recognized in 2013's AREITTI and accounts for the company's large additional cash/stock dividend of $1.55 per share for the fourth quarter of 2013. However, in sharp contrast to WMC's tax interpretation both AGNC and MTGE have deferred the derivative net realized gain over the life of the corresponding interest rate swaps/underlying swaps. Therefore, both AGNC and MTGE initially have a lower AREITTI amount in the quarter/year of occurrence due to the deferment of the derivative net realized gain. Since the rest of the sector had similar derivative net realized gains during 2013 but did not have any lofty "special" dividends declared for the fourth quarter of 2013, I would have to question WMC's tax interpretation on this particular subject.
This article also showed evidence that both AGNC and MTGE are currently trading at material (discounts) to CURRENT BV while WMC trades at a premium. When compared to the rest of the agency or hybrid mREIT sector, WMC's recent premium to CURRENT BV is highly irregular and seems unfounded. As such, I feel WMC is overvalued while both AGNC and MTGE are undervalued.
Finally, this article showed evidence AGNC and MTGE have current annual dividend forward yields that are in line with each company's agency and hybrid mREIT sector, respectively. However, WMC currently has the highest annual dividend forward yield (by several percentage points) out of all the 17 agency and hybrid mREIT sector stocks that I research. After the total dividend of $2.35 per share is accounted for (and the stock resets when the ex dividend date occurs), WMC's forward yield (based on the new reduced quarterly dividend of $0.80 per share) will calculate to nearly 22%. In my opinion, this will be highly unsustainable. Therefore, WMC's recent dividend reduction to $0.80 per share seems like it will be under a high level of stress going into 2014 while AGNC's and MTGE's recent continued dividend cuts should have stabilize the dividend going forward.
If I were currently looking to initiate or add to my position in the agency or hybrid mREIT sector based on the factors mentioned above (if it came down to a choice of these three companies), I would first look to AGNC and MTGE and would definitely avoid WMC. It is pretty easy to see WMC is overvalued and currently has a higher risk of material dividend reductions in 2014. Granted, WMC has a minor advantage regarding the added income it receives in regards to the company's larger proportion of IO strips (lower overall cost of funds rate). However, I still feel WMC is overvalued while both MTGE and AGNC are undervalued.
Disclosure: I am long AGNC, MTGE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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