By MIRIAM GOTTFRIED
The Federal Reserve?s latest round of mortgage-bond purchases is lowering borrowing rates. But QE3 is also causing plenty of pain elsewhere.
Banks, for example, are seeing net-interest margins?the difference, or profit, they make from borrowing and lending money?come under increasing pressure. Fears on that front have taken a toll on shares of Wells Fargo and BB&T, among others.
Mortgage real-estate investment trusts, or REITs, have also had a rough ride. Shares of Annaly Capital Management, the largest mortgage REIT based on market value, have fallen nearly 7% in the past month. Other mortgage REITs have suffered similarly.
A big reason: Shrinking profit margins could lead to lower net income, potentially reducing chunky dividend payouts. Annaly?s dividend yield is right now in excess of 12%.
Over the first half of the year, even before the Fed?s latest initiative to stimulate the economy, Annaly was feeling the squeeze. The company?s net interest-rate spread fell to 1.54% from 2.09% at the end of 2011.
At the same time, the wave of mortgage-refinancing activity prompted by QE3 can make matters worse as mortgage investors are given back money earlier than they expected and have to reinvest it at lower rates.
Given this, Deutsche Bank expects Annaly?s quarterly dividend to fall 10% in the fourth quarter to 45 cents a share.
Even so, investors might be tempted to pick up REITs like Annaly, given the yields on offer are still way above those of regular companies or even so-called junk bonds. But that could prove a risky gambit since Annaly and its peers have become leveraged plays on the Fed. And the real danger may not be so much that the Fed keeps rates lower for longer, but that its efforts to spur a better economic outlook work better than expected.
Already, the yield on the 10-year Treasury has moved up to around 1.8%, from levels around 1.6% seen before the Fed announced its latest plan. That has taken back some of the sharp fall in mortgage rates that came after the Fed action.
If that trend continues, especially if it gains speed, mortgage REITs could be in for even rockier times. Rising yields mean falling bond prices. That can lead to losses on holdings.
Although companies like Annaly try to protect themselves from such moves, hedges don?t always work perfectly and can grow more expensive. Also, REITs are highly leveraged vehicles. Annaly?s debt, for example, is about six times its equity.
As the financial crisis showed, leverage can be great for juicing returns when markets are going a company?s way. But it amplifies losses when conditions sour.
Annaly has a good track record of managing interest-rate cycles. Even so, the Fed?s extraordinary actions mean these are no longer normal times. Investors tempted to feast on REIT yields in these uncertain times could yet end up going hungry.
Write to Miriam Gottfried at Miriam.Gottfried@wsj.com
A version of this article appeared October 20, 2012, on page B16 in the U.S. edition of The Wall Street Journal, with the headline: Investors See the Dark Side of Fed?s QE3.
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