A steep yield curve could selectively keep earnings/dividends for agency mortgage real estate investment trusts above normal levels even though a rally in the sector is running out of steam, according to a report Wednesday by Sandler O'Neill & Partners, which is initiating coverage on the sector.

"We view the agency mortgage REIT sector as attractive, particularly for conservative investors seeking to earn low- to mid-teen returns while avoiding the credit challenges encompassing financial stocks more broadly," the company said in its equity research report. "We believe the favorable environment will likely continue into next year but are concerned that the hint of a Fed tightening cycle and/or the phase out of the Fed's MBS purchase program could deflate the stocks' upward momentum in 2010," said the report by Associate Director Michael Taiano and Associate Michael Sarcone. "Consequently, we recommend being selective within the group and buying those REITs that have more balanced models and cheaper valuations."

The company covers six agency mortgage REITs and has "buy" recommendations on two of them: Annaly and Anworth, primarily based on the former's "more diversified and balanced model, along with its track record of managing through various interest rate cycles" and the latter's "more defensive strategy toward higher rates" as well as the fact that "its valuation is the cheapest among the group."

Sandler O'Neill has "hold" recommendations on the other agency mortgage REITs it covers.

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