Your Big Dividends Could End Up Like This One

Investors can make big money from something that sounds too good to be true … but against all gut instinct, actually is true.

In today's market, one number particularly stands out. While government bonds are yielding just north of zero, we're seeing a few companies with dividend yields approaching 20%. That certainly sounds too good to be true. And I've warned about the dangers in these stocks in the past. But there just may be an opportunity here.

The big dividends
In case you haven't guessed, the stocks I'm talking about are mortgage REITs. Unlike more traditional REITs, which generate income by owning actual properties, these companies buy and sell mortgage-backed securities.

If that sounds kinda Wall Street, it is.

However, just like on Wall Street, when the good times are good, they're really good. REITs are obligated to pay out 90% of their taxable income, and the five mortgage REITs below currently support dividend yields greater than 15%.  

Company

Market Capitalization (in millions)

Dividend Yield

American Capital Agency (Nasdaq: AGNC  ) $2,566 19.4%
Cypress Sharpridge Investments (NYSE: CYS  ) $760 18.8%
Invesco Mortgage Capital (NYSE: IVR  ) $1,103 17.1%
Chimera (NYSE: CIM  ) $4,315 16.0%
Two Harbors Investment (AMEX: TWO  ) $410 15.8%

Source: Capital IQ, a division of Standard & Poor's.

But as with anything that either sounds too Wall Street or too good to be true, there's a catch. I wrote above how these high dividend yields contrast with the current low yields on Treasuries. They're actually both driven by the same thing, though -- the Fed's actions to keep interest rates low.

Mortgage REITs tend to use a lot of debt to finance their portfolios of mortgage-backed securities. When the Fed keeps interest rates low, the spread between the interest they pay on their debt and the interest they get from their mortgage-backed portfolios tends to be high. In other words, they make a killing when the Fed keeps interest rates low.

Thus, their business models take big hits when interest rates rise. When rates rise (and they will), the returns on these mortgage REITs will likely get crushed by the twin forces of a decimated dividend and a falling stock price. That's a big catch.

History lesson
In a situation like this, it helps to get some insight from the past. Interest rates have certainly fluctuated before. However, there's another catch to the catch. These companies make Google look like a grandpa. Not one of these companies was around before 2006!

How to proceed?
Fortunately, we've got one mortgage REIT with an extra decade of experience: Annaly Capital (NYSE: NLY  ) . A born-on date in the late 90's isn't that much more history, but at least Annaly has gone through a cycle of seeing rates fall, rise, and then fall again.

Most casual observers don't clearly remember this, but the Fed ramped up its fed funds rate from 1.0% in the summer of 2004 all the way to 5.25% in the summer of 2006.

We can see exactly what that did to Annaly's dividends and share price. Here's how the situation looked at the end of 2003, before interest rates started to rise.

Year Fed Funds Rate (Ending) Share Price (Ending) Trailing Dividend Yield
2003 1.0% $18.40 10.6%

Source: Federal Reserve, Yahoo! Finance, and Capital IQ, a division of Standard & Poor's.

And then here's how it looked by the end of 2006, once interest rates had risen.

Year Fed Funds Rate (Ending) Share Price (Ending) Trailing Dividend Yield
2006 5.2% $13.91 4.1%

Source: Federal Reserve, Yahoo! Finance, and Capital IQ, a division of Standard & Poor's.

First, notice that, as we'd expect in a rising interest rate environment, both share prices and dividends fell. But also notice that both drops aren't quite as bad as most would expect.

Of course, we never got to see the end of this play, since the Fed stepped in and started lowering rates in 2007.

So what does this mean?
As a general rule for any investor: Make sure you understand the catch that usually comes with a big dividend (or a low P/E ratio, a great growth rate, etc.).

More specifically in the mortgage REIT space, here are two catches that stand out from my analysis above:

  • Each mortgage REIT is beholden to the vagaries of Fed interest rate policy.
  • The industry is young, with little track record.

And one more that maybe isn't as apparent:

  • Mortgage REIT investors have to be able to trust management more than they would in more transparent industries.

History has also shown that great rewards can come with these catches, though. Since its IPO, Annaly has generated almost 600% in total returns for its shareholders. Although its stock price has doubled, most of that return owes to its choppy but huge dividend stream.

In good times, most of these big-dividend REITs will look great, pumping out huge dividends quarter after quarter. If the interest rate environment stays similar to today, all the companies I've mentioned should do quite well. In fact, Annaly probably won't even be the biggest winner. Like Wall Street during the housing bubble, the REITs that are the most leveraged and take the most risks will probably outperform Annaly.

But Annaly's track record, combined with the management prowess and experience of its respected founder and CEO, Michael Farrell, make it the best bet for the bad times. Even if its dividend yield is a "paltry" 14.5%.

If you're interested in Annaly, also consider Chimera and Crexus (NYSE: CXS  ) . Both of these REITs, while young, are managed by Annaly.

As with any too-good-to-be-true situation, I began looking into the mortgage REIT space with a healthy dose of skepticism. That hasn't entirely evaporated, but I'm sensing a real opportunity here, so I'll certainly be researching the three companies in the Annaly family further.  

For more information on Annaly, check our free report detailing five stocks The Motley Fool owns in its corporate account. Annaly is one of them, but there's another big dividend payer in there that dwarfs Annaly's track record. Click here to access the report.   

Anand Chokkavelu doesn't own shares of any company mentioned. Google is a Motley Fool Inside Value and Motley Fool Rule Breakers recommendation. The Fool owns shares of Annaly Capital Management and Google. 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 Motley Fool has a disclosure policy.


Read/Post Comments (21) | Recommend This Article (59)

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 February 08, 2011, at 3:32 PM, bmc007 wrote:

    Thanks for the article. I hold both NLY and CIM and already have gotten some real nice dividend payments from both. It's obvious that they will all head south when interest rates rise but as your article points out, it doesn't necessarily mean the party is completely over.

  • Report this Comment On February 08, 2011, at 3:36 PM, VickieDayton wrote:

    I've been trading AGNC for nearly two years and have nearly doubled my money. I love these negative-toned articles from non-traders because they may cause the week hands to sell, bring the price down and give me a chance to make some more money. Keep up the good work.

  • Report this Comment On February 08, 2011, at 4:03 PM, paul7777777 wrote:

    Cim has fallen hard during the crisis and is now slowly on the move upwards, so there's is still a huge potential to rise. Moreover even if the interest rate goes up, it will still have a dividendyield much higher then almost all other stocks, so I think it will stay a good investment, especially for people who want a nice dividendyield and a good chance of making profit besides that.

  • Report this Comment On February 08, 2011, at 4:23 PM, garyh68 wrote:

    There is a reason why you are writing the articles...

    We need more people like you... more $$$ to split for US.

    Why would you be writing harmful articles like these to damage or pull investors from nearly 20% div plus 10-20+% stock Growth? We all know the interest rate will go up but not 5% over night. There will be enough signs as to when to exit... but not by articles like this.

    If you prefer 1% interest at the Bank or 2-5% Stock yield.. then that is fine by me.

    I agree with VickieDayton.. Keep writing articles like this so that I may add to my portfolio.

    Thanks and keep up the good work.

  • Report this Comment On February 08, 2011, at 4:34 PM, mikecart1 wrote:

    ^ Your average P/E ratio of 140.07 is what we call in statistical America: bad averaging. You got one company with over 800 P/E ratio and you didn't take that out as an outlier. You basically got what you wanted to see. Next time give numbers that are actually true and not biased. Thanks!

  • Report this Comment On February 08, 2011, at 5:36 PM, sailrmac wrote:

    First just to be a picker of nits it isn't a raise in interest rates that hurts these companies persay. It is a decline in the spread between long and short term rates. If both long and short term rates rose 5% but maintained their spread relative to each other, these companies would do just fine. Not saying a rise in rates won't cause spread contraction but it's at least theoretically possible.

    Second an investor in NLY during the most unfavorable 2 period outlined didn't do so well. However, expand that to a 5 or 10 year period and include dividend reinvestments and you get a different picture.

    Third, and more important, AGNC sports a 20% yield with half of it's portfolio in adjustable rate mortgages. NLY "only" has a 14.5% yield and only 13% of it's portfolio is adjustable. In the rising interest rate situation you outline, adjustable rate mortgages would do significantly better than fixed rate.

    If you want to be in this space, AGNC is both the lower risk and better return candidate.

  • Report this Comment On February 08, 2011, at 6:27 PM, punder2 wrote:

    is it smart to hold these type of investments from the time that they announce and then sell out after they are registerd that way if they do decline you only hold them for a short time but still get the dividend i am new to this thank you

  • Report this Comment On February 08, 2011, at 6:30 PM, rd80 wrote:

    "If both long and short term rates rose 5% but maintained their spread relative to each other, these companies would do just fine."

    A jump in longer term rates isn't all good for these companies. They borrow against their mbs. A jump in rates would make new paper attractive, but would slash the value of existing paper and could leave them facing in a liquidity crunch.

  • Report this Comment On February 08, 2011, at 6:37 PM, Merton123 wrote:

    Thank you for providing the background on annaly and mortgage real estate trusts (REITs) in general. I found the information very informative.

  • Report this Comment On February 08, 2011, at 6:39 PM, Merton123 wrote:

    Thankyou for the historical background on Annaly and REITS in general. I found the information very informative

  • Report this Comment On February 08, 2011, at 8:45 PM, AddItToThePile wrote:

    Obviously you wrote this before AGNC's earnings. Up .22 in after hours trading. They're earnings speak for itself. With a balance sheet like that...There is no argument. For now, this works! It's like having an ATM for a brokerage account. Milk it while you can!

    Like what others have said...There won't be a 5% rate hike any time soon! So, until then...

    You should write something a little more productive. Or are you just running out of ideas!

  • Report this Comment On February 08, 2011, at 8:48 PM, TMFBomb wrote:

    @sailrmac,

    Yes, the interst rate spread is what's important. However, the spread for the mortgage REITs tends to contract when the Fed raises short-term interest rates.

    I was looking at the worst period for Annaly Capital to get a feel for what could happen in a rising interest rate environment. It acquitted itself pretty well...and has done a great job over the course of its existence. Of course, much of its existence has been a favorable interest rate environment.

    In terms of comparing the balance sheets of the mortgage REITs, a lot of variables factor in including the nature of the securities (as you point out), the hedging in place, and the leverage employed.

    Fool on,

    Anand

  • Report this Comment On February 09, 2011, at 3:40 AM, refriedbean wrote:

    Thanks to Merton123 for saying the same think twiice. I thought there was an echo.

  • Report this Comment On February 09, 2011, at 4:26 AM, 2spookje wrote:

    this is indeed pretty good info

    gonna dive in a little deeper

    thx fellow fools

  • Report this Comment On February 09, 2011, at 9:08 AM, THouse12 wrote:

    It is relevant to break down how things work with these MBS REIT's. They own MBS's which for the most part have fixed rate mortgages in the pools backing the security. They fund the purchase of these MBS's through some cash but MAINLY through shorter term debt. When short term rates stay low, all is well. When they rise, investors need to remember that the MBS's owned at that point in time are mainly fixed in rate so the spread income which is what is paid out in dividends, starts to shrink. To the point that long term rates rise at the same time, the spread stays good, BUT ONLY FOR NEW MBS's purchased. the existing MBS's are fixed so the majority of the income stream shrinks. Be careful if you are a short term trader as timing could hurt you, especially given that short term rates are at the historic lows of all time! I agree that if you are a long term investor that a well managed REIT should provide good returns and cash flow over time.

  • Report this Comment On February 09, 2011, at 9:28 AM, THouse12 wrote:

    One other comment on MBS REIT's, and good management. In Annaly's case, the management has a lot fo experience so they will probably try and hedge part of what I described previously and thus outperform those that don't do this nearly as well.

  • Report this Comment On February 09, 2011, at 1:58 PM, garyh68 wrote:

    The key is this.. know when you move between REIT, Oil Trusts and and any other Stocks or Funds that pays high Div.. Then use the Div to buy more of the same thus increase your Div yield.

    The Goal is this.. How much do you need per month to Quit your Job or not rely on so much the Government's hand-out when you are near retirement? ... the Best part is... Your Base continues to Grow until you actually draws on it.. Best in an IRA situation.

    My 2 Cents.. Put your 2 cents here ==> |_|

    That's my bucket! Now go get your own..

  • Report this Comment On February 09, 2011, at 3:50 PM, sailrmac wrote:

    rd80 -thank you, you make a good point.

    A rise in interest rates does hurt existing fixed rate paper even if the spread doesn't decrease. However, I'm thinking it should not hurt adjustable rate paper anywhere near as much. AGNC is half adjustable yielding 20%, HTS is all adjustable yielding 14%.

    Right now I'm invested in AGNC with a normal size position. It's tempting to double up by buying a second position in HTS. I'm thinking HTS is actually pretty low risk but am concerned about what I'm missing.

    What am I missing?

  • Report this Comment On February 09, 2011, at 5:09 PM, edward66 wrote:

    I have CIM and AGNC but do believe FTR is a good long term dividend move. I like Windstream as well.

    AGNC and CIM are both great dividend paying positions but you need to watch them very carefully. Any up tick in interest rates will push these into the dirt. So , my advice is make hay while the sun shines. and be very careful with AGNC AND CIM. I intend to move out quickly at the first sign of an upswing in the interest rates.

    I would like any advice on mutual fund postions strategy. I am retired and invest for income. 70-80% of my portfolio is in individual high yield corportate bonds and individual municipal bonds. I have recently taken a large position in tobacco settlement bonds and would like to hear any advice or experience with these investments. It is my understanding that these bonds will usually call long before their maturity dates and I have gotten very good prices and always get interest above the 5% line. Remember this is a tax free income holding !!!( you may have to pay state tax if the bond is outside your state).

  • Report this Comment On February 09, 2011, at 8:37 PM, rd80 wrote:

    @sailrmac -

    I don't think you're missing much. Even with adjustable paper, a rise in long rates would ding the value.

    From HTS factsheet, "Our investments typically have a weighted average term to the next interest rate reset date of between 44 and 61 months" That helps if longer rates rise, but still leaves a good bit of time before the assets' rates adjust up.

    HTS, and (I believe) most of the other mortgage REITs also hedge some of their borrowing rate risk.

    IMHO, once short term rates start to rise, all the mortgage REIT business models become much tougher. Holding adjustable rate paper will help, but won't eliminate narrowing spreads.

    I like the mortgage REITs in general and Hatteras in particular, largely because I think it has a little more conservative approach.

    However, these companies have had a really good run and I think we're closer to end of it than the beginning.

    I'm long HTS in real life and added a little bit last month.

  • Report this Comment On February 12, 2011, at 2:01 PM, com9600 wrote:

    Since most of these are REIT's do they have the qualfied dividend tax rate of 15%? If not maybe FTR WIN or LINE are just as good.

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