5 Dividend Kings in Danger

Interest rates have risen sharply in recent weeks, and that's been bad news for the bond market. But the repercussions of higher rates are starting to make themselves felt throughout the financial markets, and if the trend continues, then some high-yielding dividend favorites could be the next stocks to fall.

Why you should care about Treasuries
Rates on 30-year Treasury bonds jumped again yesterday, pushing the yield on the long bond above the 4.5% level for the first time since early May. Obviously, that's been terrible news for bond investors, who've seen big capital losses on their holdings in recent months.

But what you may not realize is that 30-year Treasury bonds actually have an impact on something that's incredibly important to millions of Americans: mortgage rates. In fact, there's a very strong correlation between long-term Treasuries and interest rates on 30-year mortgages, and that's has two important consequences: one for homeowners, and one for dividend investors.

Goodbye, cheap mortgages
The immediate impact from higher rates comes from people trying to buy a home or refinance their mortgages. According to figures from Bankrate, 30-year mortgage rates have jumped from below 4.25% as recently as October to 5% today. Similarly, rates on 15-year mortgages have gone up from around 3.6% to 4.3%.

That may not sound like much, but tell that to someone trying to buy a home. If you're trying to borrow $300,000, a 5% rate will cost you $1,610 per month, whereas a 4.25% rate would give you a monthly payment of just $1,475. Put another way, if all you can afford is that $1,475 figure, then the amount you can borrow has gone done from $300,000 to around $275,000.

Obviously, that's bad news for just about anyone involved in the housing market right now. Borrowers who can't borrow as much can't afford as many of the homes that are currently available. Sellers then have a smaller pool of potential purchasers, forcing them to consider cutting asking prices. And home builders Pulte (NYSE: PHM  ) and Toll Brothers (NYSE: TOL  ) in turn have to keep offering richer sales incentives to get qualified buyers to walk in the door.

Goodbye, big dividends?
The connection between Treasuries and housing is fairly easy to understand. But the other problem that investors seem to be ignoring thus far is the impact of higher rates on the mortgage-backed securities (MBS) market. Just like Treasuries, MBS prices have fallen sharply as rates have risen.

That's bad news for any investor who currently owns MBSs. And some of the biggest holders of MBSs are mortgage REITs, which have been taking advantage of huge spreads between short-term and long-term rates to reap big profits, which it then passes on to shareholders. Just look at the sheer amount of MBSs on the books of some of the most popular mortgage REITs:

Stock

Dividend Yield

Value of MBS, Most Recent Quarter

Annaly Capital (NYSE: NLY  )

15%

$76.2 billion

American Capital Agency (Nasdaq: AGNC  )

19.1%

$9.7 billion

MFA Financial (NYSE: MFA  )

10.9%

$8.0 billion

Capstead Mortgage (NYSE: CMO  )

8.5%

$7.9 billion

Anworth Mortgage Asset (NYSE: ANH  )

12.7%

$6.8 billion

Source: Yahoo Finance, SEC filings.

As MBS prices fall, these companies might have to write down the value of their MBS assets, hurting earnings and potentially forcing dividend cuts. Yet so far, none of these stocks has shown signs of falling. In fact, many of them have risen recently, perhaps because the market sees higher spreads between long rates and short rates as good for these companies.

Now it's true that most of these companies have swaps in place to hedge against interest rate swings like these. But the question is whether their hedging will be adequate. MFA, for instance, has swaps with a notional value of just $3 billion, less than half the value of its MBS portfolio. Similarly, Annaly has $25.9 billion in notional value for its swaps, while American Capital weighs in at $4.2 billion.

Also, if the companies can acquire new MBSs now, then the current wider spreads will mean more profits. But some of these REITs are already huge, and drawing more capital from investors who know that spreads are nearing their maximum will be a huge challenge.

Protect yourself
All good things must come to an end, and as the bull market in bonds appears to come to an end, rising interest rates will start being felt throughout the financial markets. It may be too late to refinance your mortgage at record low rates, but if you've been betting big on mortgage REITs, you might want to take a closer look to make sure you're comfortable with the interest rate exposure you have.

To get the best ideas for safe, reliable dividends, click here and check out the Fool's free report on dividend stocks, which includes 13 strong candidates to take a closer look at.

Fool contributor Dan Caplinger loves sniffing out danger early. He doesn't own shares of the companies mentioned in this article. The Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy keeps you out of harm's way.


Read/Post Comments (27) | Recommend This Article (74)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 15, 2010, at 10:44 AM, Fitzcap wrote:

    While NLY may reduce dividend in future, I doubt if they will cut it for this quarter. I'll stick around for the 3.75% yield in 2 weeks and the stock is still up pretty good the last few weeks

  • Report this Comment On December 15, 2010, at 11:23 AM, bmc007 wrote:

    Fitzcap, I agree and fully intend to do the same.

  • Report this Comment On December 15, 2010, at 11:32 AM, roberthanover wrote:

    I think for the next 1 to 2 years we have more to worry about than inflation and high interest rates. That is so 1980's. We are coming out of a small depression. We have to worry about deflation. We have to worry about jobs. The pressure on job pay increases will be a minus nill for quite awhile and last I looked that was # one in inflation and inflation was number # in high interest rates. Just thinking.

  • Report this Comment On December 15, 2010, at 2:51 PM, rockbox64 wrote:

    This is fearmongering. Plain and simple.

  • Report this Comment On December 15, 2010, at 3:42 PM, mikenpdx wrote:

    think about it for a minute though. if interest rates skyrocket and stay there, it will kill any economic recovery we are experiencing and it will make an already bad housing market even worse.

    what's bad for the economy is bad for the stock market in general and under this scenario, at some point money exits the stock market and presumably heads for the safety of bonds again sending rates back down.

    combine that with the Federal Reserves mandate that low rates are needed for an extended period and their efforts to help ensure that and I don't think you can come to the conclusion that rates are moving up for good now.

    if they do stay up, look out below.

  • Report this Comment On December 15, 2010, at 6:16 PM, dividendgrowth wrote:

    What kind of nonsense is that?

    These MBS players love big interest rate spreads. The bigger the difference between long term and short term yields, the more money are they going to make, as long as the underlying MBS do not default.

    I don't know about the others, but Annaly only buys government secured MBS so the possibility of default is very slim, at least until 2012.

    What can kill their cash cow is a sharp rise in SHORT TERM interest rate. For example in 2006. when the yield curve became inverted, Annaly cut its dividend all the way down to 5%.

  • Report this Comment On December 16, 2010, at 8:55 AM, DivingDan wrote:

    And 5% is a low yield for a dividend? No lie I'm loving the 15% as I bought Annaly near it's bottom but I'll still enjoy the payout even if it dropped to 5%.. still a lot higher than most other companies and a solid track record for maintaining their spread.

  • Report this Comment On December 17, 2010, at 9:00 AM, Party23 wrote:

    2nd for DivingDan

  • Report this Comment On December 17, 2010, at 10:55 AM, Jim747 wrote:

    Who is buying AGNC at ove $29.00 a share when it is being offered at below $27.44 on the additional offering?

    What I'm I missing???

  • Report this Comment On December 17, 2010, at 12:49 PM, DadsFroggie wrote:

    I have been holding NLY since 2003. In that time there have been some ups and downs in the price but the dividends have been solid relative to the overall market. My take on it is that the market already has the stock valued at a yield of 5-8% so I don't see a huge likely downside.

  • Report this Comment On December 17, 2010, at 1:27 PM, whyaduck1128 wrote:

    I own some NLY and will be neither buying nor selling. Even if the interest rate spread is reduced, it won't disappear, and therefore neither will its profits. If my dividend yield goes from over 14% to 6% or something like that, I'm not going to weep, as I'd still be getting 6%.

  • Report this Comment On December 17, 2010, at 1:39 PM, mclaugph wrote:

    Agree with other posters -- this feels like fearmongering. I don't think this is an immediate concern, but NLY is a stock that I watch pretty closely and will dump if I think it's going into freefall.

    Maybe I'm not understanding this, but I thought yield % was tied to share price. I'd think the share price would be impacted more by rate changes than yield %...so if NLY's dividend gets slashed in half but the price falls by the same amount your yield is unchanged.

    (Still newish to this, so please correct me if I'm wrong.)

  • Report this Comment On December 17, 2010, at 2:42 PM, investanickel wrote:

    So, does this same argument have the same impact for AFSI or ARCC?

  • Report this Comment On December 17, 2010, at 4:22 PM, NoFoolRules wrote:

    They (REITs) make their money from the spread between the short and long end of the yield curve... right now the Fed is at zero percent and long end has moved up a bit. So if anything they are more profitable now than before. What you need to watch for is the Fed moving the short term interest rates which hasn't happened as the Fed recently reiterated this past week.

  • Report this Comment On December 17, 2010, at 4:33 PM, 702nitro wrote:

    Yes the 6% yield is bettor than any rate you'll get out of any savings, CD, or stock, but where you lose money "capital" is in the share price as interest rates increase.

    I've got a decision to make, if interest rates keep going up and the SP trends to a lower price, I think it would be a smart move to sell now, buy when the price drops and stabilizes, and then enjoy the divs again. Alternatively you could just take advantage of the situation and cost average your way in again.

  • Report this Comment On December 17, 2010, at 4:51 PM, benoitlj wrote:

    I'm holding on to NLY -- their management (i.e. Michael Farrell) is absolutely brilliant. I've owned this stock since 2001 and have never been disappointed. Case in point, NLY just declared an INCREASE in the next dividend from $0.60 to $0.64. I also own MFA, though, and I'll be taking a close look at this one.

  • Report this Comment On December 17, 2010, at 5:00 PM, millionairhead wrote:

    Da, doy-doy...

    Of course increasing interest rates will depress these stocks!!!!!!

    I own every single one of them.

    Ain't no dam ANAL-ist but I can read. Interest rates ain't gonna mess these guys up for the next quarter or 2 at least. Between appreciation and high-yeild...they've been better than growth stocks for me the last year.

    It also don't take an ANAL-ist to know when better deals elsewhere. I didn't marry 'em. Time comes...we'll break up.

    Give some thought to where to put your financial sector money when conditions become unfavorable and be ready...

    Meantime....cha-ching

  • Report this Comment On December 17, 2010, at 5:22 PM, sshobe wrote:

    Any problems with owing REIT's in an IRA account?

  • Report this Comment On December 17, 2010, at 5:46 PM, 702nitro wrote:

    @benoitlj

    How did you get from .60 to a .64 div distribution???

    3Q NLY paid out .68 per share to common shareholders, while 4Q will be paying out .64/share.

  • Report this Comment On December 17, 2010, at 8:08 PM, TMFGalagan wrote:

    @sshobe -

    REITs don't usually generate unrelated business taxable income, which is the thing that makes some investments no-nos in IRAs.

    best,

    dan (TMF Galagan)

  • Report this Comment On December 17, 2010, at 8:17 PM, TMFGalagan wrote:

    @divingdan -

    I agree that 5% would be a completely reasonable yield. But a lot of investors in mortgage REITs haven't gone through a complete business cycle owning them and are under the mistaken impression that they'll always pay 10%+ yields. It's those folks who need a wake-up call that things can change in a hurry with mortgage REITs.

    best,

    dan (TMF Galagan)

  • Report this Comment On December 18, 2010, at 9:08 AM, labrun1 wrote:

    So if I understand, these dividends are ok for

    at least 1-2 quarters? What about stops on the share price.

  • Report this Comment On December 18, 2010, at 5:41 PM, jm7700229 wrote:

    @sshobe, the answer is no. REITs get no tax advantage, so they might as well be in an account that will be taxed in full upon withdrawal. It's actually probably the best kind of investment to have in an IRA from a tax standpoint (ignoring risk, of course).

  • Report this Comment On December 18, 2010, at 7:49 PM, corriehubbs wrote:

    Since we pay no taxes on Roth IRA account, is that a good play to hold high yield like NLY?

  • Report this Comment On December 20, 2010, at 10:33 PM, perrysharon wrote:

    is agnc a hold for now or sell

  • Report this Comment On December 22, 2010, at 4:33 PM, 1caflash wrote:

    Notice MFA raised Its Dividend by One Cent. I bought some 12-21-10. This Firm would not have done that if It did not feel Confident about 2011. This is my First Investment in MFA. I agree with Everyone Who Says Interest Rates Cannot Go Up Too Fast Too Soon, or Our U. S. Economy Will Be Derailed. Enjoy Owning Shares of Fine Companies like MFA, Annaly, Chimera and ARCC. Let Them Pay You [What A Deal!]. Relax, and Have Some Joyful Holidays.

  • Report this Comment On December 28, 2010, at 8:03 PM, MiserableOldFart wrote:

    I have a little in ANH, some in MFA and more in CIM. I sold a few shares of CIM a couple weeks ago, but holding onto all of the above for the near term, unless some great buy jumps out at me and I need to raise some cash. Don't see short term rates going up any unless the kooks and morons that got elected in November can really clamp down on the Fed as they want to do. They would love to sabotage the economy and then blame it on everyone else per usual, but they didn't win THAT big that they can get away with it if the supposedly sensible ones left have any cojones.

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