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.

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.