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%.  

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.

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.

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.