Stay Away From This 25% Dividend Yield

When something sounds too good to be true, it usually is.

I recently came across a stock with a 25% dividend yield -- great, right? A little digging convinced me to pass on this stock. Read on to find out what the stock is, why you should stay away from it, and another high yielding stock for your consideration instead.

High yield
If you know something about high-yield stocks, you may have guessed that the 25%-yielding stock is a mortgage REIT (mREIT). You'd be partially correct.

For those unfamiliar, mortgage REITS are real estate investment trusts that make money by buying mortgage-backed securities and collecting the interest. If you've looked at mortgage rates recently, you'll realize that investing in mortgages on their own doesn't return much. With the Federal Reserve buying billions of dollars of mortgages every month, mortgage backed securities return just 1%-1.5%.

To boost these returns, mortgage REITs borrow heavily to increase the amount of mortgages they can buy. This enables them to pay out the large dividends that investors love. The important thing for mortgage REIT investors to track is the spread between the return on the bonds and the cost of the money mREITs are borrowing, as well as the mortgage REIT's total level of borrowing compared to its equity.

Mortgage REIT 

Spread

D/E

TTM Yield

Annaly Capital Management (NYSE: NLY  )

1.02%

6.2

14.9%

American Capital Agency (NASDAQ: AGNC  )

1.42%

7.9

16.3%

Two Harbors Investment (NYSE: TWO  )

3.30%

4.2

13.4%

MFA Financial (NYSE: MFA  )

2.22%

3.2

11.1%

Source: Capital IQ.

The stocks have been supported by investors' unquenchable thirst for dividends; however, there are two things mREIT investors should worry about.

First, mREITs have huge amounts of debt. Whenever you are investing using huge amounts of debt, small miscalculations or deviations from the expected can cost you everything. Also, a rise in interest rates, while not likely till 2014, would potentially wreak havoc on companies reliant on debt.

Second, the spreads mortgage REITs earn are declining, and the safest yields are under further threat from government action. That means smaller dividends going forward.

Spreads are declining because of Operation Twist, the Federal Reserve's $40 billion per month purchase of mortgage-backed securities (eerily similar to our 2010 April Fool's joke). In this program, the Fed borrows money by selling short-term bonds and uses it to buy long-term MBSes. This greatly increases demand for MBSes, pushing down the interest rates they pay.

Spreads are under further threat as current head of the Federal Housing Finance Agency, Edward DeMarco, may be on the way out. This is a potential problem for some of the largest mREITs in that Demarco was strongly against the Treasury using funds to reduce principal on underwater mortgages, which the Obama administration and Treasury Secretary Tim Geithner were very much for. Refinancing underwater mortgages would be a problem for the mREIT industry as this would open huge amounts of previously unrefinanceable mortgages to refinancing. Refinancing is bad for mREITs as previously issued, higher-than-current interest mortgages get paid off and replaced with lower yielding mortgages, eating into mREITs spreads.

25% yield
So how do you get a 25% yield from a mortgage REIT?

Just add more debt. Seriously.

In October, UBS launched the ETRACS Monthly Pay 2x Leverage Mortgage REIT ETN (NYSEMKT: MORL  ) . Similar to an ETF, an ETN, or exchange traded note, borrows an equal amount compared to its assets to double its bet on a collection of mortgage REITS. The leverage gives this ETN an expected yield of 24.82%.

If it sounds too good to be true, it probably is. This product just adds more debt to a collection of mREITs that are already very highly levered. With 2 times the leverage, owning the ETRACS Monthly Pay 2x Leverage Mortgage REIT ETN it is similar to owning the previously mentioned mREITs with twice the debt levels. Sure, you also get twice the yields, but you have twice the downside risk. These four mREITs are the four largest positions in the ETRACS Monthly Pay 2x Leverage Mortgage REIT ETN.

Exposure at 2 times leverage

Mortgage REIT 

Weighting

2x D/E

Annaly Capital Management

19%

12.4

American Capital Agency

14.5%

15.8

Two Harbors Investment

5.2%

8.4

MFA Financial

5.17%

6.4

With these weightings and a 2 times exposure, at those debt levels, small, adverse moves to Annaly or American Capital Agency, or moves to the mortgage REIT sector as a whole, can spell disaster for an investor in the ETRACS Monthly Pay 2x Leverage Mortgage REIT ETN.

It's also important to note that the ETN is meant to track 2 times the monthly return on the index. With all leveraged products, there is near certainty that the ETN will diverge significantly from the index over longer periods than it's designed for as the leverage is reset monthly and the costs of the derivatives the ETN uses to track the index eat into the ETNs returns.

For example, if over a two-month period, the mREIT index moved down 10% in the first month, then up 10% in the second month, the 2x index will finish more than 2x down from the regular index over the entire period.

 

Month 0

Month 1 (-10%)

Month 2 (+10%)

Index (Total Return)

$100 (0%)

$90 (-10%)

$99 (-1%)

2x index (Total Return)

$100 (0%)

$80 (-20%)

$96 (-4%)

While the ETN doesn't have as much tracking risk as some of the products that are meant to track the daily movements of indices, it's still a near certainty.

Foolish bottom line
Stay away from the ETRACS Monthly Pay 2x Leverage Mortgage REIT ETN.

Annaly Capital Management has a history of paying huge dividends to shareholders. But there are some crucial issues investors have to understand about Annaly's business model before buying the stock. In this brand-new premium research report on the company, our analyst runs through these absolute must-know topics, as well as the future opportunities and pitfalls of their strategy. Click here now to claim your copy.


Read/Post Comments (7) | Recommend This Article (22)

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 December 05, 2012, at 3:16 PM, Michaelb123a wrote:

    This is a new ETN, so who knows? All the caveats listed here are so yesterday's news. Not all of these MReits are plain vanilla, ready to eat brands of the same thing. If you do not understand what you are purchasing then you only have yourself to blame. Enough said.

  • Report this Comment On December 05, 2012, at 3:57 PM, TMFDanDzombak wrote:

    @Michaelb123a It's not like this ETN is a mystery box , you know what you are getting and it's a bad bet for any time longer than a calendar month. Most investor's should stay away from this.

  • Report this Comment On December 06, 2012, at 2:20 AM, Clint35 wrote:

    I love the ticker. MORL, as in the moral of the story is clear; stay away.

  • Report this Comment On December 12, 2012, at 2:54 PM, Dwightfish wrote:

    This was published the day after your article. It does not seem to support your 25%hypothesis. Am I missing something?

    MORL : Valuation Date 11/30/12

    Ex date 12/11/12

    Record date 12/13/12 Paymentdate12/21/12

    Amount $0.1043

    Monthly 5.02%

  • Report this Comment On April 02, 2013, at 4:03 PM, sailrmac wrote:

    So far MORL is behaving almost exactly opposite what you predicted. A combination of MORL's top 4 holdings: NLY, AGNC, TWO, MFA is essentially at the same price they were at on 10/17/2012 when MORL started. MORL on the other hand is up 20%.

    I don't understand why, and am looking into it further.

  • Report this Comment On February 09, 2014, at 1:49 AM, Jon408 wrote:

    It would be nice if the author responded to some of the comments. Lack of response after inviting comments indicates a certain lack of interest - which doesn't make much sense.

  • Report this Comment On August 05, 2014, at 6:49 PM, MJT73106 wrote:

    What a miss this one was! Dan Dzombak probably hasn't put this on his highlight reel.

    Just think, for people that did not follow his advice and actually invested in MORL, they received an annualized return of nearly 22% over the past 18 months. That is in excess of over $8 in dividend/interest per share.

    When people do not understand something they mock it as being unsafe or too expensive.

    All I can say is that if you believe that interest rates will remain relatively low over the next 5 years, you return could be enormous. Do some research...

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