Two weeks ago, I wrote a column about seven high-yielding dividend stocks' exposure to "Operation Twist," the Federal Reserve's ongoing program to decrease long-term interest rates. That article raised so many concerns among readers that I've decided to expand upon it here.
I believe that these seven dividend stocks are so risky that you should steer clear of them until further notice. To avoid leaving you empty-handed, however, I link to a free report at the end of this article that details 13 high-yielding dividend stocks with significantly less exposure to the ongoing economic trends.
Dividend stocks and risk
Many investors believe that dividend-paying stocks carry less risk than their non-dividend-paying brethren. This belief probably arises because of the type of company that typically pays a dividend (an older, more stable company) relative to the type of company that doesn't (a younger, riskier company).
Although this belief may be true as a general rule, there are exceptions to it -- one of which is the real estate investment trust, otherwise known as a REIT.
As the name suggests, a REIT is a company that invests in real estate directly, either through properties or mortgages. To keep its tax-free status, however, a REIT is obligated to distribute at least 90% of its taxable income to shareholders through dividend payments.
To stress this pivotal point, a REIT is obligated to pay dividends regardless of whether it is a young and risky upstart or an older company with an established track record -- which, in turn, raises the question: How should investors measure a REIT's risk?
The relationship between yield and risk
Although requiring a REIT to pay out 90% of its income inhibits equity growth, doing so makes it easy to assess the market's perception of its risk. Like a bond, a REIT communicates risk through yield: The higher the yield, the higher the risk, and vice versa. I've accordingly included six benchmark yields for you to use when assessing a specific REIT's risk level relative to the market.
Benchmark Indexes and Securities
|Average REIT dividend yield||6.17%|
|iShares Dow Jones US Real Estate ETF||4.32%|
|Vanguard REIT ETF||3.41%|
|SPDR Dow Jones Wilshire REIT ETF||3.24%|
|Dow Jones Industrial Average||2.86%|
Source: screener.co and The Wall Street Journal (as of Oct. 10, 2011).
The average REIT pays a 6.17% dividend yield. This is higher than what the three largest REIT exchange-traded funds (ETFs) offers, probably because ETF fees cancel out a certain amount of yield. It's also higher than the yields of the Dow Jones Industrial Average and the S&P 500 because the companies therein are not obligated, like REITs, to pay dividends.
The savvy investor, in turn, will view yields well in excess of these benchmarks with a high degree of skepticism. For example:
Interest Rate Spread
|Invesco Mortgage Capital (NYSE: IVR )||22.6%||2.75%||5.2:1|
|American Capital Agency (Nasdaq: AGNC )||20.6%||2.36%||7.5:1|
|Chimera Investment (NYSE: CIM )||18.8%||4.20%||1.9:1|
|ARMOUR Residential REIT (NYSE: ARR )||18.6%||2.36%||8.7:1|
|CYS Investments (NYSE: CYS )||18.3%||2.23%||8.1:1|
|Two Harbors Investment (NYSE: TWO )||17.7%||4.10%||4.2:1|
|Annaly Capital Management (NYSE: NLY )||15.2%||2.07%||5.7:1|
Sources: Yahoo! Finance and the investor-relations pages of the respective companies.
I don't mean to belabor the point, but it's extremely important to compare these two tables. The yield of the seven REITs in the second table is anywhere from 2.4 to 3.7 times the yield of the average REIT and more than 4 to 6 times the yield of an average of the three largest REIT ETFs.
These aren't the trusty old dividend stocks found in your grandmother's attic. These are high-risk investments, equivalent in my mind to an upstart tech firm or a bricks-and-mortar retailer in the midst of the e-commerce revolution.
What makes them so risky
I want to make it clear that not all REITs are like this. Indeed, many have significantly lower yields and thus, presumably, less risk. Equity Residential and Apartment Investment & Management immediately come to mind. These companies invest almost exclusively in apartment buildings -- a business that's booming, given the foreclosure crisis. And as a result, their yields are a more modest 2.50% and 2.10%, respectively.
The REITs in the table, on the other hand, are mREITs -- REITs that invest in pools of individual mortgages. They borrow money at low short-term interest rates and lend that money out at higher long-term interest rates through mortgages or mortgage-backed securities. They then pocket the difference, otherwise known as the "interest rate spread."
This model is 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's done courtesy of Operation Twist -- the Fed's program to reduce long-term borrowing costs.
The conventional conforming 30-year fixed rate mortgage recently fell below 4% for the first time in history:
Source: Freddie Mac, "Primary Mortgage Market Survey for 2011."
Though some observers may argue to the contrary, there's simply no question that this long-term trend, accelerated by Operation Twist, will decrease the profit and, thus, dividends that REITs distribute to shareholders. The only question is when. And speaking from personal experience, it isn't fun to be the only one left standing when the music ends.
Foolish bottom line
My hope is to apprise you of the relationship between yield and risk, and to urge you to look very closely before investing in a stock with an unusually high dividend yield. Although some of them may turn out just fine, chances are most won't once the party stops.
Still, I don't want to leave you without ideas of where to get yield. I strongly encourage you to read our free report about 13 high-yielding dividend stocks. In it you'll find dividend stocks that are far less vulnerable to Operation Twist than the mREITs I've mentioned here. Access it while it's still free and available.