These 7 Dividend Stocks Are Extremely Risky

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

Dividend Yield

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%
S&P 500 2.17%

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:

REIT

Dividend Yield

Interest Rate Spread

Leverage

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.

Fool contributor John Maxfield, J.D., has no position in any of the securities mentioned in this article. 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 (18) | Recommend This Article (33)

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 13, 2011, at 5:17 PM, OutperformOrDie wrote:

    Thanks for the warning, John.

    I own NLY and have felt that it's an extremely risky play for quite some time. Something about a 16% dividend without any strings attached raises a few red flags for me.

    It's funny, though, that ResearchTeam, Sabrient Investment Research and also TheStreetRatings all have it listed as a "buy."

    Guess you can never be too careful.

  • Report this Comment On October 13, 2011, at 5:50 PM, JohnMaxfield37 wrote:

    Hey OutperformOrDie -

    When the market went down, we started recommending NLY heavily because of the movement in interest rates.

    In 2005, for example, the yield curve was basically horizontal, making it tough for a company like NLY to pay a dividend. And as a result, NLY cut its dividend from $0.68 to $0.10 in a period of less than three years.

    Once the market went down and the yield curve starting moving up, however, the interest rate spreads were amazing. Thus, the current yield and our recommendations.

    There's two schools of thought on what this looks like going forward. One says that the yield curve will stay steep for a while, and thus there's no reason to move out of high-yielding mREITs. The other says that the Fed will flatten the yield curve by bringing down long-term rates, which is what they're doing with Operation Twist.

    Either one, however, is a gradual process so THERE'S NO URGENCY TO ACT EITHER WAY (though, I do recommend that you keep a close eye on what NLY's doing with its quarterly payouts, as they've lately been decreasing).

    The other concern that I didn't address in the article itself is the political possibility that the insurance on some of these mortgages may not be there when the time comes. And given their leverage, I believe this would be existential for mREITs.

    At the end of the day, I just don't see these mREITs as viable long-term holds.

    Thanks for the comment!

    John

  • Report this Comment On October 13, 2011, at 5:53 PM, Lordrobot wrote:

    I disagree for the simple reason that Operation Twist never worked in 1961 and is not working now. The trouble with forcing down the bond yield on the long notes is that speculators are buying the long notes to take advantage of the gov pump on capital gains. That is exactly what happened in 1961. So instead of making the long bond less attractive, the unintended bernanke consequence is the opposite.

    This is just another version of QEII and it is the economic philosophy which is flawed.

    Bernanke surmises that bidding down bond yields will send investors out of long bonds and into more risk oriented investments. But he is missing a few facts.

    First the flush state of businesses has them in need of a place to put lots of money. Banks insure accounts only to 250K so a corporation is at risk and so they buy long bonds in large quantities regardless of the yield. But thanks to Bernanke Twist, the corporations have been rewarded in terms of capital gain.

    Thus, twist is moronic, did not work in the 60s and will not work this time either. It is common sense that Bernanke lacks.

  • Report this Comment On October 13, 2011, at 8:48 PM, dsandman999 wrote:

    Most of these mREITs have already done large secondary offerings and invested them in long term instruments with lifetimes much longer than the Fed can keep Operation Twist going. The only exposure there would be the ones maturing in that time period and any new funds they have to invest. Both are a small percentage of thier long term portfolios. Deleveraging short term with it would also be a good use.

    On the short term side, the instruments they use are probably longer lived than Twist will be as well. The roll over numbers will make a difference since it will be a larger number, but the rates could double from current and the same leverage will still produce great returns on these stocks.

    I think Operation Twist is going to fail simply because the long term rates are already historically low. Even if you drop a 4% to 3% you are not going to spur much economic activity, especially with the restrictions in lending and subpar appraisals the banks are working with.

    Since I have mine in my IRAs, I do not worry about things like short and long term capital gains, but I suspect a few of them will be taking the gains on some long terms and keeping to maturity the short terms. Tax planning might need to be considered by folks keeping them in regular acounts.

  • Report this Comment On October 13, 2011, at 10:23 PM, revealedin71 wrote:

    John...Two other points to consider,somewhat related...If the bond vigilantes ever show up and demand higher rates, short and long term, the Fed could have a real fight on it's hands. And if the bond/government debt bubble breaks, we also could be in a situation of "what if they gave an auction and nobody cared"....The yield curve could stay steep.,..just at higher levels. What then for our mortgage reits?

  • Report this Comment On October 13, 2011, at 11:15 PM, roydale wrote:

    Hi John,

    Just want to say that I think that you are completely missing the boat here.

    It's true that these are essentially leveraged bond funds. But it is also true that thanks to the fat net interest margins (NIM's) -- and owing to a healthy dose of caution in the wake of 2008 -- all of these funds are employing significantly less leverage than they used to do.

    It's true that, over time, lower long term rates and a flatter yield curve will cause the net interest margins and the dividends of these agency REIT's to drift lower. But so what? The yield for NLY is currently over 15%. If I promised you a rock solid yield of 8% in this market, would you turn up your nose?

    The primary risk for these businesses is not a bull flattener -- yield curve flattening in a bullish rate environment -- but a BEAR flattener -- a rapid rise in SHORT TERM interest rates that would crucify them as it causes their profitability to plunge at the same time that the book value of their longer duration assets was declining (due to higher interest rates).

    That would be a nightmare.

    But don't all of the economic statistics suggest that we are flirting with recession? And aren't all of the newspapers featuring daily stories about austerity, credit contraction, imminent sovereign defaults and the possibility of QEIII? Didn't the Fed just promise us -- explicitly -- that they would not raise short term rates until 2013?

    So what would cause an unanticipated spike in short term rates that would hammer funding costs for these leveraged bond funds?

    One thing that could do it would be some sort of systemic failure in the banking system that caused banks to withdraw funding from the agency mbs REITs. But this seems unlikely -- especially since money funds are hungry for high quality short term yields -- because agency mortgage repo (which pays about 0.25%) is one of the highest quality short term credit out there, next to T bills (which yield 0%). Repo borrowing is an obligation of the borrower AND it is collateralized by govt guaranteed paper with a substantial "haircut" or margin -- i.e. discount to market value.

    Another thing that could do it would be a $US crisis -- a flight from the $US -- which could cause short term U.S. rates to spike. I don't see that in the cards over the near term. Do you?

    Another thing that keeps agency REIT investors up at night is the notion that the SEC might suddenly put them out of business by changing the rules of the game. But does that make sense to you....in an environment in which the Fed is executing Operation Twist to lower long term rates to stimulate the economy -- and specifically to provide support to the housing market? Now how could the SEC be so obtuse as to suddenly force the liquidation of hundreds of billions of dollars of mortgage assets by some of the largest buyers in the market. Does that make sense? And to what end?

    Suppose the SEC DID do this. Would that be a tragedy? I doubt it -- especially since NLY is trading at approximately 95% of book value and ANH, HTS and CMO -- other prominent agency REITs - are trading closer to 90% of book value. They could liquidate and return money to shareholders IN EXCESS of current stock prices! (Only AGNC trades at 100% of book value).

    What else could go wrong? The government could suddenly decide to give everyone in the county a new mortgate -- a refi -- at 3%, causing massive prepayments. Sounds like a good way to stimulate housing, right? Except that many mortgages currently have LTV's of over 100% -- which is highly problematic -- and many of the largest holders -- if not THE largest -- holders of mortgage assets trading above par (and the are ALL trading above par) are financial institutions.

    Suppose this program were put into effect, prepaying mortgages at par that are currently held by financial institutions and are worth prices between 100 and 115. Is that a good way to rebuild bank capital? And what will they replace these short duration assets with -- new, long duration assets with fantastic interest rate risk yielding 3%? That seems counter productive.

    So if the REITs don't have a funding crisis -- and the made it through 2008; and the SEC doesn't put them out of business -- and why would they; and the current administration doesn't call in every current outstanding mortgage loan (or a significant number) -- and how could they; then you'll just have to get used to collecting 15% per year -- gradually drifting lower, thanks to Operation Twist -- in a 0% interest rate environment.

    BTW, thanks to Operation Twist, it appear that the book values of these REIT's is approximately the same at end of Q3 as at end of Q4 -- unchanged.

    Did I mention that most of them are trading around 91% of book value (NLY at 95%; AGNC at 100%)? That means that you'll be obligated to pay 91 cents on the dollar for the privilege of collecting those 15% dividends.

    Personally, I think that they've all gotten trashed because the entire financial sector has been savaged and we're all waiting for the other shoe to drop in Europe. Fair enough.

    I also think that some investors have been spooked by the SEC circular seeking comment on the REIT structure. They are likely going to see more regulation; but I don't think they are going out of business through a forced deleveraging. The comment period ends in a few weeks. Then what? It may be months before there is any definitive pronouncement on this issue -- so they'll probably remain in the dog house for awhile.

    If short rates soar -- unexpectedly -- all bets are off.

    But suppose the SEC imposes new rules to make their business model challenging. What will happen to them? Will they trade down to 80% of book value? Why wouldn't they all liquidate (or partially liquidate and buy back stock) if that is the case?

    On the other hand, suppose that the REITs that are currently trading at 91% of book value return to something more traditional -- like 110% of book value -- over the next year. Your total return would be 110 / 91 = 21% PLUS the 15% dividend: 36%, give or take. Not too shabby.

    Conversely, suppose the stocks LOSE 15% -- for all of the reasons that you cite. Chances are that the dividends would remain the same -- or roughly similar -- over the next twelve months (unless the bear flattener crushed us all). You would break even after collecting your dividend.

    You may wish to place this bet but if you were short -- and wrong -- you stand a good chance of losing your shirt on that one.

    I'll take the other side of your trade -- all day long.

    That's what makes a market!

  • Report this Comment On October 14, 2011, at 5:53 AM, paultaut wrote:

    I believe mREITs like Agency/NLY which have their risk built into their price should be avoided like the proverbial "Plague".

    "It's true that, over time, lower long term rates and a flatter yield curve will cause the net interest margins and the dividends of these agency REIT's to drift lower. But so what? The yield for NLY is currently over 15%. If I promised you a rock solid yield of 8% in this market, would you turn up your nose?"

    To presuppose that the price will stay the same if the yield is halved is wishful thinking.

    If the yield is cut in half, it will mean that earnings will have also dropped by around 50%. (They are required to pay 90%)

    Any stock whose earnings drop by 50% would be reamed, you will spend years recouping the Capital loss.

    IMO

  • Report this Comment On October 14, 2011, at 10:55 AM, mrmcook wrote:

    John,

    I realize the risk that you bring up, but then why haven't you convinced the Motley Fool as your disclaimer clearly states the The Motley Fool owns shares of Annaly Capital Management and Chimera Investment?

  • Report this Comment On October 14, 2011, at 2:24 PM, benbie wrote:

    I expect the dividends to go down over time, but I also expect the resultant yields to be better than what I can get elsewhere.

  • Report this Comment On October 14, 2011, at 2:58 PM, WmHilger1 wrote:

    I totally agree with benbie!!! Plus, I would rather take these nice double digit dividends over the short term and collect less SOMEDAY (which might be a long time in coming), than accept lower dividends now and possibly even lower ones later!

  • Report this Comment On October 14, 2011, at 3:50 PM, JohnMaxfield37 wrote:

    mrmcook -

    Because mREITs are cyclical in nature, if you buy them when the interest rate spread is broadening and sell before the spread narrows, they turn out to be pretty good investments. And while I wasn't privy to the Fool's decision to purchase NLY and/or CIM, I suspect these dynamics had something to do with it. In terms of how long we'll hold them? Your guess is as good as mine. But it'll likely be triggered by movements in interest rates.

    benbie and BillinOmaha-

    I can't argue with your thesis. You don't see short-term dividend plays often, but they do come along!

  • Report this Comment On October 14, 2011, at 4:40 PM, JohnMaxfield37 wrote:

    roydale -

    Your insight is much appreciated.

    There's no denying that the current economic environment may provide mREITs temporary safe-harbor.

    At the same time, there's a lot of systematic risk in the market that revolves around mortgage-backed securities. This risk, while no doubt extreme, is clearly being considered by the market. Thus, these ridiculous yields.

    What I would add is that because these are countercyclical investments, by going long, you're basically betting on things getting worse (a counter-countercyclical bet, if you will).

    While I don't necessarily disagree with you, I'm not certain that would actually be good for mREITs. An uncontrolled resolution of the crisis in Europe, for example, could leave credit markets seizing - obviously not a good outcome for mREITs.

    On the other hand, if things get better, short-term rates will increase, and yields will go down. Also not good for mREITs.

    Thus, as I see it, mREITs maintain these or similar yields only if the present economic malaise drags on indefinitely - the least likely option as I see it.

    I'll conclude by revisiting what you said at the end: It takes two to make a market. Truer words were never spoken.

    Thanks again for the comment!

    John

  • Report this Comment On October 14, 2011, at 7:23 PM, jm7700229 wrote:

    I don't believe that mREITs behave like bonds. The underlying assets are not subject to the same market risk: with most of these, they are insured/ guaranteed and are marketable at near face value. The Twist doesn't seem to have had any effect on the existing mortgage market: refis are down, not up and mortgage interest rates have increased by a few basis points. Twist hasn't changed the much tougher mortgage rules now being used.

    Over a period of years, like 5 to 7, the spreads will converge, but will not go away. I expect these to continue to be high yielders for the near future.

  • Report this Comment On October 17, 2011, at 12:48 PM, randallw wrote:

    "While I don't necessarily disagree with you, I'm not certain that would actually be good for mREITs. An uncontrolled resolution of the crisis in Europe, for example, could leave credit markets seizing - obviously not a good outcome for mREITs."

    If Europe collapses and credit markets seize, the Fed will drop money from planes (see: QEI and QEII). They will also continue to print money until America is deleveraged, which will take years at the current pace. As long as the Fed continues to intervene, shirt-term rates will remain low. Count on it.

  • Report this Comment On October 17, 2011, at 7:56 PM, sailrmac wrote:

    John,

    If you are buying at 90¢ on the dollar, even if mortgage rates came down such that the spread halved, it isn't the end of the world. Your yield declines, but your YTM, not so much. In this scenario, the spread halving, if the agency REIT's just held and let there books run out, they would make quite a decent return.

    Best Wishes,

    Sailrmac

  • Report this Comment On October 18, 2011, at 10:32 AM, ganeshsastri wrote:

    Rule 1. Treat all dividends as return of your OWN money.

    Rule 2. Work out your yield based on future EPS divided by current market price.

    Yields on M Reits are attractive. Evidently market is factoring a fall in future EPS.

  • Report this Comment On October 26, 2011, at 6:50 PM, JohnCamMac wrote:

    Apart from all of the above(some of which is very insightful), it is possible to write covered calls on AGNC at least.

    You can write a Jan 28 call for perhaps 80 cents after the drop in after hours tonight.(They are issuing more shares.) That represents about $3.20/yr, or about 11%/yr additional that way.

    Combined with the dividend, and combined that they have plenty of cash to pay it AND expand their business, I'm comfortable owning AGNC.

    John

  • Report this Comment On November 08, 2011, at 1:27 PM, marc5477 wrote:

    A lot of the replies on this article are funny... you guys do realize that mREITs generally trade at around BV right? Even when spreads tighten, the stock never really fell much less than BV-20% (not including odd market spikes). So to say that NLY has a chance to crash back to the levels of 2005 is asinine. Their BV is much higher and people know it.

    Go back and look at BV vs. PPS charts on NLY. You will quickly note the correlation between the two. In fact, they are more correlated than yield vs. pps. If pps were directly correlated to yield, then NLY would have been a $3 back in 2005 but instead it traded at $11 which was close to BV.

    Anyway... im sure most people wont even read this lol.

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