Yesterday marked another historic move by the Federal Reserve to keep the federal funds lending rate near zero through late 2014. This is significantly longer than the projection of mid-2013 that the Fed has been giving the market for months now.
This news is music to the ears of prospective homebuyers and anyone looking to refinance a rather strenuous debt load. But it's also incredibly good news for one particular sector of the stock market -- mortgage real estate investment trusts.
Mortgage REITs turn a profit on the difference between the rate at which they borrow (the federal funds rate) and the higher rate at which they lend. After paying for day-to-day operations and reinvesting in the business, they dole out at least 90% of the remaining income to shareholders. As interest rates rise, the amount of profit that mortgage REITs bring in shrinks as well because their margins contract. With the Fed pledging to lock in rates at historic lows for at least the next two-plus years, it has essentially given the green light to go mortgage-REIT dividend hunting.
Take a look at just some of the current yields in the mortgage REIT sector:
Annaly Capital Management
American Capital Agency
Invesco Mortgage Capital
Source: Yahoo! Finance.
The first thing you'll notice is the consistency in delivering high yields across the sector. With the assurance from the Fed that lending rates will remain low through 2014, this gives many of these companies a green light to continue to be a little more aggressive, which should, in the end, translate into more dividends.
Another thing to remember is that not all mortgage REITs are created equally. Annaly Capital, for instance, invests the majority of its portfolio in U.S. government-backed securities. Although these aren't risk-free, it's nearly as close as you're going to get. Agency Capital also invests in government-backed securities, but boasts significantly more leverage than Annaly. If interest rates don't move against it, the payoff from the extra leverage could be worth it. Capstead, on the other hand, boasts more leverage than Annaly, but it has one of the lower interest-rate spreads. Finally, Invesco and Chimera invest in riskier assets that aren't necessarily backed by the U.S. government. This strategy can be just as profitable as Annaly's or Agency Capital's, but it can also carry more implied risk without the safety of AAA-rated government securities.
There is always the chance as well that mortgage rates could continue to fall and mortgage REITs' spreads could shrink. Most interest rate spreads, as Fool colleague Ilan Moscovitz has so kindly pointed out for us, are off their highs, but are still high by historical standards.
That's a risk I personally am willing to take, and it's just another reason that income-seeking investors need to be paying very close attention to the mortgage REIT sector.
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