The Hidden Force Behind This High-Yielding Dividend

I've spent a lot of time of late investigating the exorbitantly high dividend yields of certain real estate investment trusts. My thesis has been that these high yields reflect high risk. And as a result, I advised readers to be wary of seven specific high-yielding mortgage REITs.

In this short piece, a part of my "chart of the week" series, we'll look at a chart that illustrates what makes a mortgage REIT like Annaly Capital Management (NYSE: NLY  ) profitable. As you'll see, it has very little to do with the REIT itself, and much more to do with the surrounding economic environment.

How mortgage REITs make money
Essentially, mortgage REITs profit by borrowing money at low short-term interest rates and then lending it out at higher long-term rates in the form of mortgages and/or mortgage-backed securities. The difference between the two is called the interest-rate spread.

Pretty nice business model, eh?

Well, before you pour all of your money into a mortgage REIT, you should know that this spread changes over time. In 2005, for example, the spread between the 2-Year Treasury Note and the 10-Year Treasury Bond was 0.18%. That same spread today is 1.56%, 8.5 times as large!

And with these changes go a REIT's dividend payment, as illustrated in our chart of the week.

Sources: Yahoo! Finance's historical prices page for NLY's dividend payment, and the United States Department of the Treasury for the interest-rate spread data.

Annaly's dividend per share (denoted on the right vertical axis) closely shadows the interest-rate spread between the 2-year and 10-year Treasuries (denoted on the left vertical axis).

Although the current spread is great for Annaly shareholders, you can see how it turns around quickly. In 2005 and 2006, for example, the interest-rate spread between the 2-year and 10-year Treasuries fell to less than zero. And as a result, Annaly cut its dividend per share from $0.68 to $0.10 in just over three years, which triggered its share price to drop by roughly 40%.

Consequently, even though the dividend yields of the mREITs in the following table may seem great now, there's no telling how much longer that'll remain the case.

REIT

Dividend Yield

Interest-Rate Spread

Invesco Mortgage Capital (NYSE: IVR  ) 22.6% 2.75%
American Capital Agency (Nasdaq: AGNC  ) 20.7% 2.36%
ARMOUR Residential REIT (NYSE: ARR  ) 18.8% 2.36%
CYS Investments (NYSE: CYS  ) 18.3% 2.23%
Chimera Investment (NYSE: CIM  ) 18.4% 4.20%
Two Harbors Investment (NYSE: TWO  ) 17.7% 4.10%
Annaly Capital Management 15.2% 2.07%

Sources: Yahoo! Finance and the investor-relations pages of the respective companies.

Because so much of this depends on the Federal Reserve, the trick is to know if or when the Fed will initiate a bond buying or selling program to change the relationship between short- and long-term rates, as it's done with Operation Twist. The general rule is that the Fed keeps the spread low when the economy is expanding and thus inflationary, and high when it's contracting and thus deflationary. The next time you're thinking about buying, selling, or holding an mREIT, in turn, you'd be wise to see what kind of mood Ben Bernanke's in before doing so.

Foolish bottom line
Although high-yielding REITs can make great investments for someone looking for yield, they also carry significant interest-rate risk that could jeopardize that yield. For more on how to identify interest-rate risk, read my column about seven risky dividend stocks.

Otherwise, add Annaly Capital Management to My Watchlist to see how it performs through these shaky times.

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 (15) | Recommend This Article (17)

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 14, 2011, at 11:53 PM, ffllooyydd wrote:

    Dummy, in one sentence you talk about REITS and in the nest you talk about mREITS. There's a difference you dummy.

  • Report this Comment On October 15, 2011, at 9:52 AM, Mohawk1510 wrote:

    Yes, the sky may fall. But if you had boughtAGNC for 19.65 (its high on May 15, 2008) and held until today, you would have received $17.46 in dividends and hold a stock worth $27.65 at yesterday's close. Not bad apples. Yes, the borrowing/lending spread may narrow and one has to be nimble enough to get out when this happens. However, with the Fed promising low rates for probably the next two years, that will be another $11.20 in dividends. Your continual fear mongering has just cost people a lot of money. If there were a way, I would eliminate all Motley Fool infomercials from the message boards.

  • Report this Comment On October 15, 2011, at 12:26 PM, karlm1 wrote:

    It will probably save most people more money than it will make for some. Most people are not skilled or as nimble as the few that are. Joe Iowa will be tempted to put his hard earned money chasing these easy money yields yields if he listens to the few who believe they know how to time these investments. The great majority of investors will lose their shirt when these stocks start to drop quickly in price and also cut their dividends. This article just points out the real risks of owning these stocks. This is just like chasing any other bubble.

  • Report this Comment On October 15, 2011, at 5:27 PM, BobGern wrote:

    Forgive my ignorance but I have two questions.

    1) Why are the interest rate spreads listed with the REITS not all the same?

    2) Where can I find a site that gives me the current interest spread expressed in one number?

  • Report this Comment On October 15, 2011, at 7:35 PM, JohnMaxfield37 wrote:

    Hey Bobgern-

    Good questions.

    First, the interest rate spreads are different because the mREITs have different borrowing costs. Some borrow overnight on the repo markets. Some borrow on 1-month maturities. Etc. So each will be slightly different.

    Also, the interest they get on their investments depends on what they've invested in: straightup mortgages, uninsured mortgage-backed securities, insured mortgage-backed securities, etc.

    Second, the best places are bloomberg and the treasury department. They don't actually calculate the spreads but they give all the interest rates, so it's easy to calculate them yourself. The links to these two sites are:

    Treasury: http://www.treasury.gov/resource-center/data-chart-center/Pa...

    Bloomberg: http://www.bloomberg.com/markets/rates-bonds/government-bond...

    Hope that helps!

    John

  • Report this Comment On October 15, 2011, at 7:39 PM, JohnMaxfield37 wrote:

    karlm1 -

    I appreciate the comment.

    You're exactly right. These yields look like bubble yields. They may be perfectly fine companies (though I'd probably beg to differ in the long-run), but why buy in so high?

    When Annaly reduced its dividend to $0.10 in 2005, it's share price went down by 40% in four months. A lose-lose proposition for sure.

    John

  • Report this Comment On October 15, 2011, at 9:24 PM, BobGern wrote:

    Two follow up questions.

    1) So, lower the interest rate spread that the REIT

    has borrowed at makes it more safe than one that has borrowed at a higher rate...ARR safer than CIN?

    2) According to the yield curve on the links you provided, the rate is 3.25%. Is this the correct current interest spread or does a separate calculation have to be done?

  • Report this Comment On October 15, 2011, at 9:25 PM, BobGern wrote:

    CORRECTION:

    ARR safer than CIM?

  • Report this Comment On October 16, 2011, at 9:49 AM, JohnMaxfield37 wrote:

    BobGern -

    With respect to your second question...

    The interest rate spread is the difference between a long-term interest rate and a short-term interest rate. People use different spreads for different purposes. For example, you can look at the difference between the 30-year and the 1-year. Or the 10-year and the 6-month.

    I used the spread between the 2-year and the 10-year treasuries. So, it's calculated by subtracting the interest rate on the 2-year (.28%) from the interest rate on the 10-year (2.26%) to get 1.98%. And again, these numbers are available on that Treasury site I cited earlier.

    In terms of your first question...

    The interest rate spread of each company depends on the interest rate their creditors charge them and the yield they get on their investments in mortgages/mortgage-backed securities. So, it's all relative. A company may have a large spread because they borrow cheap. That would be good. Or, the spread could be large because they're investing in highly risky mortgages that pay high interest rates. I would say that's bad.

    I wish I could say that a high or low interest rate spread, in and of itself, communicated relative risk, but I can't. You really have to look at why each company's spread is what it is. You can generally get that information from a company's quarterly or annual reports.

    At the end of the day, what I would warn about these as investments is that there is a "black box" element to them. It's virtually impossible to know what they have in their mortgage portfolios. If only a small percent of their portfolios are rotten and uninsured, and they're highly leverage, then it wouldn't take much to push them into bankruptcy.

    Hope that helps.

    John

  • Report this Comment On October 16, 2011, at 1:05 PM, BobGern wrote:

    Thanks for taking the time to educate me, John. It is much appreciated!

  • Report this Comment On October 17, 2011, at 10:05 AM, Mohawk1510 wrote:

    John, of course, there is no way to document whether your advice will save people more money and they would have made investing in AGNC. It is said that a bear is the smartest guy in the room because he always appears to have a good reason for his position, while the bull is the one that makes the money. We just happen to disagree about the risks on MREITs with agency MBSs. In two years or so when MREITs start going down, I will come back to tell you how much I gained or lost. In the meantime, I keep banking the 20% yield.

  • Report this Comment On October 17, 2011, at 12:28 PM, JohnMaxfield37 wrote:

    Mohawk1510 -

    I hear what you're saying. And you may very well may be right. But there's a fundamental difference between someone who's owned AGNC since '08 and someone who's thinking about buying it now. You've already collected a significant amount, so your downside is limited. New investors are not similarly protected.

    Beyond that, AGNC has only been around since 2008. So it's only seen the best of times for mREITs. As a result, its capacity to absorb low interest rate spreads is completely unproven.

    That's why these are so risky. It doesn't mean they won't ultimately be fine investments. It does mean, however, that there's an above-average risk that they won't be. So for the typical income-seeking investor (retired, etc.), this much risk is probably inadvisable.

    You have to look at something like this as if you're investing in a risky growth stock. I like to do that. You may like to do that. But some people don't.

    John

  • Report this Comment On October 17, 2011, at 12:34 PM, cliffkemp wrote:

    Anyone can pick out a specific time frame and say..." I told you so"...

    If people are not going to be smart enough to see what may happen based on economic factors that point to these companies potentially taking a hit, they should not be investing...

    With that being said, current conditions make for good yields by these companies and the ONLY reason the prices are fluctuating are due to articles that many 'uninformed' investors take at face value and react.

    For the arthor...I will not get rude as it is not needed but, stocks are risks as most know. Telling us what may happen X amount of time down the road and quoting a specific time in the past to back up your statement is a little rude...As any investor should know, past performance does not gaurantee future performance of any stock.

    To others that read articles and take them to heart....DON'T....Do your homework and use common sense. Those 2 things will get you where you want in the long run when investing.

  • Report this Comment On October 17, 2011, at 9:21 PM, Mohawk1510 wrote:

    Well, we can all differ about the risks. That is what makes the market. I will just note that AGNC is one of Todd Johnson's "7 Must-Own Dividend Stocks For 2012" over at Seeking Alpha and he has had a pretty good feel for MREITs. However, I have talked to other people who feel that they are too risky. If you feel that way, you shouldn't invest in them. There are many other ways to make money in the market. I do not want to push AGNC on anyone. Just to provide the counter argument. Good luck to all.

  • Report this Comment On October 19, 2011, at 4:22 AM, cliffkemp wrote:

    The belief that the Federal Government can control mortgages and make things 'better' for the masses is comical. Interest rates will not go up until the housing market gets better. Changing the rates to historic lows has not and will not help the over all situation as it had little to do with rates to begin with except for those with ARM's. REIT's are the thing now due to the court system is backed up with forclosures for nearly 3 years in some states and most are upside-down on their loans. Simply giving a lower rate and refinancing is not going to solve the problem as 'Operation Twist' may suggest. This may take a decade to get better. (my opinion) Writing articles to scare people is not the way to go about it as we do not know what is going to happen. I believe the fed is not going to raise rates until we get a new President at best. We will find out in just over a year. For now, Reit's are decent investments with 'higher' risks than some people may want to stomach and therefore, should not invest in them if that is the case. Just follow the news and weed out the bias and you will get a decent take on the immediate future on these types of stock and where they are headed.

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