7 Dividend Stocks That Could Burn You

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.

REIT

Dividend Yield

Interest Rate Spread

Leverage

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
Chimera Investment 18.06% 4.20% 1.9:1
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.

Fool contributor John Maxfield has no financial stake in any stock mentioned above. The Motley Fool owns shares of Annaly Capital Management and Chimera Investment. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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 (16) | Recommend This Article (47)

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 October 01, 2011, at 2:21 PM, JimmyDoors wrote:

    I'd feel more comfortable with your analysis if you didn't repeatedly misspell the name of ARMOUR Residential REIT, Inc..

  • Report this Comment On October 01, 2011, at 4:37 PM, JohnMaxfield37 wrote:

    JimmyDoors -

    My apologies. I nevertheless urge you to separate the error from the analysis.

  • Report this Comment On October 03, 2011, at 10:34 AM, pondee619 wrote:

    "I nevertheless urge you to separate the error from the analysis" Of course you do. But is it possible to separate the lack of attention to detail that the mistake shows from the analysis? How is one to know that the same lack of attention does not carry over to the analysis? Sloppy writing= sloppy analysis= poor advice= fool articles.

    fool writers are clearly under a mandate to pump out "articles" at a rate the precludes proper proof reading. (fact checking?). Mr. Maxfield is not alone in this. It is rampant among this community.

  • Report this Comment On October 03, 2011, at 11:48 AM, techy46 wrote:

    "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." I think you're wrong. First, the FED doesn't want to drive up short term rates just lower the spread between short and long. Second, my understanding of NLY is that they make their profits on the spread between short-term rates and long-term GSE MBSs. I really doubt 15-30 yr mortgage rate will go much below 4% thus they spread is safe.

  • Report this Comment On October 03, 2011, at 12:16 PM, JohnMaxfield37 wrote:

    techy46 -

    You're right with respect to the Fed's intentions.

    Like yours, my understanding is that the Fed's intent is simply to lower the spread by bringing down yields on its long-term bonds.

    To keep its balance sheet neutral, however, the Fed is selling an equivalent amount of short- and medium-term notes - which despite the intent will likely raise the yield on the short-term notes.

    And this is exactly what has happened.

    Since September 20th, the yield on the 2-year went from .15% to .24%, an increase of 59%. And the yield on the 5-year went from .77% to .95%, an increase of 23%.

  • Report this Comment On October 03, 2011, at 2:07 PM, techy46 wrote:

    Don't you think the yield in short terms is going up because of flight to safety because of EU concerns rather than FED's policy and will be very short lived. Regardless NLY isn't doing well today.

  • Report this Comment On October 03, 2011, at 2:35 PM, JohnMaxfield37 wrote:

    You are unquestionably right about the flight to safety. However, one would expect all U.S. yields to go down in light of it, though some more than others.

    Take a look at these charts for the 2- and 5-year yields (look at the interactive graph on the bottom half of the page):

    2-year chart: http://www.bloomberg.com/apps/quote?ticker=USGG2:IND

    5-year chart: http://www.bloomberg.com/apps/quote?ticker=USGG5YR:IND

    As you can see, both yeilds abruptly changed course in immediate proximity to the Fed's announcement.

  • Report this Comment On October 03, 2011, at 4:05 PM, chadscards1274 wrote:

    I guess the one question I would ask is look at the above yields and assume that each is only able to make 50% of what they do now. In the worst case they yield would be 7+% and in the higher yielders it would be 12+%. Considering some of these REITs are selling at single digit future P/E's even if their yields were cut in half (a drastic assumption) they would look to be fair values versus say an overvalued utility stock.

  • Report this Comment On October 03, 2011, at 5:26 PM, JohnMaxfield37 wrote:

    MHenage -

    That's a great question!

    If we put our common sense hats on, I suspect you and I would agree that yields this high are suspicious. I mean, think about it -- yields above 20%. That's growth stock territory.

    My guess is that there's concern about the fundamental business model here.

    Assuming that's true, we can analogize it to Greek gov't bond yields. Yes, if you cut Greek gov't bond yields in half, you're still making a pretty penny. But yields like that don't get cut in half. They go away, along with the underlying instrument.

    It's important to remember that yield reflects more than opportunity cost. It also reflects risk.

    Now, I could be totally wrong on this. But like I said at the beginning, my common sense keeps bringing me back to the same conclusion.

    Hope that answers your question:)

  • Report this Comment On October 03, 2011, at 6:25 PM, chrissie9898 wrote:

    i think your wrong about these stocks. Ive held all of them for long time. They have made me some money

    and i look forward to an early retirement.

    Any investment in any stock is a risk, these just have more of a risk, if you are not willing to take a risk then just dont buy these. For that matter dont get into the market at all.

  • Report this Comment On October 03, 2011, at 9:13 PM, JohnMaxfield37 wrote:

    chrissie9898 -

    That's great to hear these stocks have made you money. And if you've held them for awhile, I'm sure you're really happy with the return.

    You're exactly right that the question of whether to buy/sell/hold these stocks (or any stocks for that matter as you note) is a question of risk tolerance.

    That said, risk is a moving target. Stocks that are risky today may be very stable ten years from now and vice versa. Buying Amazon.com when it went public in 1997, for example, was very different than buying it today. And buying Eastman Kodak was a great decision in the late-1970's but would be convincingly less so today.

    The question, in turn, is where on this arc are these mREITs?

    Here's what I would say. mREITs face a lot of exposure right now to a narrowing interest rate spread (which the Fed is committed to effectuating) and to the short-term credit markets (the state of which is anybody's guess once Greece formally defaults). As a result, they are much riskier now than they were a few months ago.

    The good thing for you, of course, is that with risk comes reward -- i.e., yield. And the more yield you get, the earlier you can retire. Consequently, while I have a slightly different take on these stocks than you do, I both relate to and respect your reason for investing in them.

  • Report this Comment On October 04, 2011, at 11:26 AM, dsandman999 wrote:

    Since these REITS have almost all recently done secondary offerings and already invested in the long term contracts at the relitively higher rates before twist, they should not need to buy much at the lower rates. They should be locked in for several years.

    Depending on how long the Fed is able to sustain the policy, it probly is not going to make that much of a difference even on thier short term borrowings. Depending on thier roll over rate, they probably will see a gradual decline in profits based on leverage, but even if the 2 year goes from the .24 to .5 that is only going to shave 1.95% for AGNCs 7.5x leverage and that assumes all thier short term debt is rolled over. It is yeilding 20.5% at todays price. AGNC at over 18% is still a great deal.

    For a short period I suspect these Reits will deleverage a bit with the idea that the Feds actions would be short term effects compared to thier current portfolios.

    Thier long term portfolios are also going to be going up as the interest rates go down.

  • Report this Comment On October 07, 2011, at 2:04 PM, Threedollarbill wrote:

    Thanks for the article. I own shares in NLY. My biggest question though, is even though these high yielders certainly are attractive, if you bought 20 shares of NLY for $15. = $300., and the stock price takes a nose dive to $8. or somewhere below, due to the instability of the company or economic turmoil, the yield is great, but you could still take a beating and not make any money or end up in the red.

    So what's the best way to analyze these REITs to determine the less risky? Do you look at the spread on debit?

  • Report this Comment On October 08, 2011, at 1:16 PM, JohnMaxfield37 wrote:

    Hey Threedollarbill -

    Before getting any further, let me tell you why I'm concerned. I've been spending a lot of time looking at the situation in Europe. The bond yields over there are high to put it mildly. Greece's one-year yields are something like 140%. I mean, ridiculous.

    The important lesson here is that yield compensates for risk.

    So apply this lesson to REITs, and what do you get?

    Quite frankly, I can't think of a riskier market right now than real estate (other than European sovereign debt, of course). And to make matters worse, REITs are in the cross-hairs of the Fed's Operation Twist - which appears to be working. Just this week, the 30-year fixed mortgage rate fell below 4% for the first time in history!

    I mean, that's incredible. These rates are jaw-dropping. And they will inevitably hurt REITs because they narrow the interest rate spread.

    So back to your question, what do you look at?

    Start with the yields relative to industry peers. You can get this on a stock screener like finviz.com.

    Then compare that with the respective company's debt-to-equity ratio --their leverage. You'll see a strong correlation here between yield and leverage.

    Then, if you really want to get to the bottom of it, you'll need to dig into the REIT's themselves. What do their mortgage securities look like? When did they originate? What's the percent in default? Unfortunately, as you'll find, REITs have a "black box" aspect to them, that makes them hard for the individual investor to analyze.

    Finally, and more accessibly, you might want to look into the people who run the REITs. Read up on the executives. See if they've posted videos on Youtube. I know for a fact that NLY's CEO has numerous videos on there. Check them out. Get a feel for the people who have your money. Do they give you a good feeling or a bad feeling?

    I know that's a lot, but it may be a worthy cause if you have a bit of money in them.

    Also, I'm going to post a column here in the next week about these REITs that you should read if you're still interested. The analysis therein will basically be what I just laid out.

    Hope that helps!

    John

  • Report this Comment On October 15, 2011, at 3:05 PM, ABondie wrote:

    It seems to me that the spread is only one factor to consider. If the spread narrows because short term rates go up then the hypothesis of the article makes sense and the effect is reduced earnings and lowered dividends. However, if the yield spread narrows as a result of long term rates going down, while you have the same impact on earnings there is a substantial increase in the value of the mortgage assets already held. Would this not be reflected in an increase in net asset value and positively effect the value of the stock? Where am I wrong about this?

  • Report this Comment On October 16, 2011, at 10:02 AM, JohnMaxfield37 wrote:

    ABondie -

    With mREITs it's all about the spread. Because these are leveraged funds, they rely on earnings to service debt.

    Moreover, because mREITs pay out 90% of their earnings in dividends, the value of the underlying stock is mainly a function of the dividend and not the quality of the assets owned.

    Here's what I would say, look at the relationship between (1) the interest rate spread between say the 2-year and 10-year, (2) the size of an mREIT's dividend payment, and (3) the value of its stock.

    I compare (1) and (2) in the following article: http://www.fool.com/investing/general/2011/10/14/the-hidden-...

    You may also be interested in: http://www.fool.com/investing/general/2011/10/13/these-7-div...

    John

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