High yield investors have been chasing the attractive dividend payouts offered by the mortgage REIT sector for years and years now. Unlike the high payouts from telecom, tobacco, and utilities stocks, the mortgage REIT sector is far from defensive. The effects of quantitative easing (QE) from the Federal Reserve and the potential unwinding of that QE may be adding more pressure (and risk) on a sector where the dividend can disappear on investors almost overnight.

Bank of America Merrill Lynch has a detailed report on the high yield dividend mortgage REIT sector. Some REITs are viewed favorably and others are viewed with caution. The report covers the following: American Capital Agency Corp. (NASDAQ: AGNC); Annaly Capital Corp. (NYSE: NLY); ARMOUR Residential REIT, Inc. (NYSE: ARR); CYS Investments, Inc. (NYSE: CYS); Dynex Capital, Inc. (NYSE: DX); and Two Harbors Investment Corp. (NYSE: TWO).

What is so interesting about today’s report is that this shows that the tapering off of quantitative easing by the Fed is posing a risk as well as just the effects of quantitative easing. The prepayment risk likely remains in place and a Fed exit to QE3 may steepen the curve on the sector.

We have outlined the notes and ratings with a target price on each below. Also included were the consensus target and the price today. These have been posted in notation format to shorten the report. Be advised that the current share price is as of mid-Monday and reflects ongoing weakness as most mortgage REIT stocks were down 1% to 3% at the time.

American Capital Agency: Adjusted EPS was $1.09, which was modestly better than the adjusted EPS of $1.07 in Q4. This suggests the run-rate earnings from the portfolio improved in Q1, but it was also shown that book value fell by 8.6%. BofA showed that some of this weakness has likely reversed in Q2 as rates have fallen and economic optimism has waned, but it warned that shares are likely to react negatively to the results as investors will focus on lower book value despite the essentially steady interest income. Rating: maintained Buy with $33.50 target; consensus target is $32.91 and share price is $29 today.

Annaly Capital: BofA put core EPS at $0.28 versus a $0.35 forecast, reversing realized and unrealized gains and losses. Asset sales contributed to higher than expected margin compression and book value fell by 4.2% to $15.19 from $15.85 per share. Rating: Maintained Neutral with $14.75 price target; consensus price target is $15.29 and shares are at $14.60 today.

ARMOUR Residential REIT: taxable EPS of $0.25 was better than BofA’s $0.24 estimate due to a $0.05/share gain but book value fell 8% to $6.69 from $7.29 per share after agency RMBS prices declined during the quarter. The stock is now valued at a 13.0% yield, suggesting investors will continue to recognize healthy current income, though the high BV volatility implies valuation will remain at a discount to peers, in our view. Rating: Maintain Neutral with $6.50 target; consensus is $6.97 and the REIT trades at $6.10 today.

CYS: Gains continue to offset spread compression with $0.32 per share earnings. BofA maintained a Buy rating here as book value was down by 3% to $12.87 from $13.31 per share. BofA thinks that CYS will react favorably to the reported results. Rating: Maintained Buy with $13.50 target; consensus is at $13.23 and this is $11.75 today.

Dynex Capital: investors will apply a modest discount on Dynex versus peers because its 11% dividend yield is at the low-end for hybrid mortgage REITs. BofA does expect that book value will expand as it retains earnings and monetizes its net operating loss. Rating: $10 price target; consensus price target is $10.88 and shares are $10.70 today.

Two Harbors Investment: reported Q1 core EPS of $0.29 versus the $0.32 consensus, but book value fell by only $0.35 during the quarter to $11.19 from $11.54 per share despite distributing $1.33 of dividends. Book value would have been up 8.5% without the dividend and investors should react favorably to the results. Rating: Reiterate Buy with $13 target versus $11.95 today.

By now you can tell that not all mortgage REITs are created equal and they do not necessarily get viewed in tandem nor in a vacuum. For those investors who choose to avoid the risks of the individual mortgage REITs, there is the Market Vectors Mortgage REIT ETF (NYSE: MORT) with a yield of about 10.3% as of its latest quarterly dividend payment.

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