Will the U.S. Downgrade Doom These High-Yielding Stocks?

This article is part of our Rising Star Portfolios series. You can read about the Dada Portfolio here.

With Standard & Poor's recent downgrade of the United States' credit to AA+, lots of dividend investors have been asking if the downgrade will doom high-yield mortgage REITs.

As a reminder, residential mortgage REITs raise capital by issuing shares to the public, leverage that capital to buy mortgage-backed securities, and then pay shareholders the profit that results from the difference between the interest they collect on their investments and the interest they pay their creditors.

That difference -- known as the spread -- has been absurdly high since the short-term interest rates fell to their current rock-bottom lows after the financial crisis. This has allowed residential mortgage REITs to pay massive dividends to shareholders.

Here are the ten highest-yielding stocks:

Company

Cost of Borrowing

Interest Rate Spread

Leverage

Dividend Yield

Invesco Mortgage (NYSE: IVR  )

1.50%

2.8%

5.3 times

22.0%

American Capital Agency (Nasdaq: AGNC  )

0.90%

2.5%

7.4 times

19.4%

ARMOUR Residential (NYSE: ARR  )

0.99%

2.4%

8.8 times

19.1%

Cypress Sharpridge (NYSE: CYS  )

1.10%

2.3%

7.5 times

17.8%

Two Harbors (NYSE: TWO  )

0.50%

4.3%

5.4 times

16.9%

Chimera (NYSE: CIM  )

2.40%

4.2%

1.9 times

16.7%

Capstead Mortgage (NYSE: CMO  )

0.60%

1.8%

8.8 times

14.7%

Hatteras Financial (NYSE: HTS  )

1.10%

2%

7.4 times

14.4%

Annaly Capital (NYSE: NLY  )

1.60%

2.5%

5.8 times

14.2%

Anworth Mortgage (NYSE: ANH  )

1.10%

1.9%

7.4 times

13.9%

Source: Capital IQ, a division of Standard & Poor's. Financial data is of the latest quarter.

I've actually purchased shares of two of these names -- Annaly Capital and Chimera -- in the real-money Dada portfolio I co-manage for The Motley Fool.

But are the good times coming to an end?

Concerns about the health of REITs stems from the fact that, like many financials, they rely on a pretty serious amount of leverage in order to juice their interest rate spreads. Unlike, say, traditional banks, which leverage their loans on top of a stable base of liabilities (deposits), REITs usually get their funding on the "repo" market for overnight loans. If day-to-day creditors get spooked and demand their money back, that could doom a REIT much like a traditional bank run would doom a bank. This is the stupid situation Lehman Brothers and much of the financial sector faced during the 2008-2009 credit crunch.

Unlike Lehman, however, most of these REITs (with the partial exceptions of Chimera, Two Harbors, and Invesco) focus on buying what are known as "agency securities," mortgage-backed securities whose payment is guaranteed by Fannie and Freddie, and, therefore, the full faith and credit of the United States. Until now, that has meant cheap borrowing costs, because creditors know that REITs have safe portfolios. But with S&P questioning that full faith and credit a little, some are concerned that the safety of those portfolios might come into question as well. S&P has downgraded Fannie and Freddie to AA+, too. If creditors get spooked, REITs' cost of borrowing could rise, reducing profitability and/or dooming some companies.

The other way REITs could be doomed is if investors demand higher interest rates on short-term Treasury bonds, pushing up borrowing costs for all short-term loans.

If trouble were to happen, the ones to be wary of are those which own lots of non-agency securities, have high leverage, are improperly hedged, and employ less-experienced management teams.

So far, however, none of this has happened. Ironically, treasuries have soared and interest rates have plummeted following S&P's downgrades. 10-year bond yields have fallen from 2.77% to 2.15% since the start of the month as investors fled stocks and flocked to treasuries. Treasuries soared across the yield curve -- including 30-year bonds.

What's going on? When investors are afraid, they run to safety. Investors continue to consider U.S. Treasuries to be among the safest places to park their assets, and this month, there's been plenty for the market to fear. We saw a major rating agency downgrade the U.S., weak economic reports, and budget cuts that economists at banks like JPMorgan calculate will weaken the economy further by destimulating the economy. Pimco CEO Bill Gross, who manages the world's largest bond fund, warned that we face a greater-than-50% chance of another recession unless the government takes aggressive steps to "create a demand for labor" by repairing and upgrading infrastructure: "Capitalism in its raw form can't pull us out of this hole."

The market has been so much more worried about the economy than deficits or what ratings agencies think. As a result, interest rates are basically tracking economic expectations. So, barring a rapid economic recovery, another financial crisis that kills the repo market, or renewed concerns that members of Congress will try to force the country to default, interest rates -- and therefore dividends -- will probably stay attractive for these high-yielders for at least a couple more years.

Click here to add these high-yield REITs to your stock watchlist. And if you're looking for more great dividend stocks, check out "13 High-Yielding Stocks to Buy Today."

Ilan Moscovitz doesn't own shares of any company mentioned. You can follow him on Twitter @TMFDada. The Motley Fool owns shares of Chimera Investment and 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 Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (14)

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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 August 24, 2011, at 9:22 PM, blesto wrote:

    No comment, except for, well uh, maybe - nah.

    No comment.

  • Report this Comment On August 25, 2011, at 9:52 AM, dheffernan wrote:

    This is the same story rehashed in an attempt to sell services. Nothing new here. Only thing mentioned was possibility of yeldcurve flattening by the short rates increasing. And Bernanke already said there is two years of "not likely'.

  • Report this Comment On August 25, 2011, at 8:13 PM, alanddee wrote:

    I Really think Two and CMO aren't that bad in fact Im buying more at the low prices they are.Everybody get all excited when a good stock goes down instead of buying more they sell what they have and loss money.These 2 stocks will still be here but at a heigher price......Alanddee

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