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In a recent column on the market's hottest dividend sector, a colleague of mine identified three concerns that are weighing on shares of mortgage REITs like Annaly Capital Management (NYSE: NLY ) and Chimera Investment (NYSE: CIM ) .
After expanding on the greatest of these threats, I provide a link to a free report that our equity analysts recently released about their 13 favorite high-yielding dividend stocks.
A mortgage what?
As the name suggests, mortgage REITS operate as pseudo-banks in the real estate business. They borrow money at short-term interest rates and then use it to invest in real estate directly or indirectly through long-term mortgage-backed securities.
A mortgage REIT's profit derives from the interest-rate spread between short-term interest rates and the yield on their long-term investments, including mortgage-backed securities.
The spreads on well-known mortgage REITs fluctuate around and between 2% and 4%. At these rates, a REIT will return between $2 million and $4 million in profit, not including overhead expenses, for every $100 million that it lends out in the form of mortgages or related securities.
Interest Rate Spread
|Invesco Mortgage Capital (NYSE: IVR )||25.62%||2.75%||5.2:1|
|American Capital Agency (NYSE: AGNC )||20.48%||2.36%||7.5:1|
|AMOUR Residential REIT (NYSE: ARR )||19.35%||2.36%||8.7:1|
|Two Harbors Investment (NYSE: TWO )||18.16%||4.10%||4.2:1|
|CYS Investments (NYSE: CYS )||18.09%||2.23%||8.1:1|
|Annaly Capital Management||14.37%||2.07%||5.7:1|
Sources: Finviz.com and the investor-relations pages of the respective companies.
One reason the dividend yield on mortgage REITs is so high relative to the S&P's average of 2.28% is that they generally use leverage to juice their returns. For every $1 that AMOUR Residential has in equity, for example, it has nearly $9 in debt. This model is wonderfully profitable when short-term interest rates are low relative to long-term rates, but it becomes markedly less so if this relationship changes, as it is likely to do courtesy of the Federal Reserve's recently announced "Operation Twist."
How Operation Twist burns REITs
The purpose of Operation Twist is to spur long-term investment by reducing the cost of long-term borrowing. To do so, the Fed will buy $400 billion of long-term bonds (with maturities of six or more years) and sell $400 billion of short-term securities (with maturities of less than three years).
The intended result of Operation Twist, in turn, is to force short-term interest rates up and long-term interest rates down. That will narrow the interest-rate spread that REITs rely on to make money and pay a generous dividend.
Although REITs can mitigate the impact on their profit with even more leverage, doing so leaves them reliant on a credit market that is increasingly fragile in light of a potential recession and the ongoing events in Europe.
Foolish bottom line
If you're looking for safer dividend plays without exposure to Operation Twist, I strongly encourage you to read our free report about 13 high-yielding divided stocks. In it, you'll find dividend stocks that are far less vulnerable to Operation Twist and anything else the Fed may have up its sleeve. Access it while it's still free and available.