If you need to draw cash from your investment portfolio in order to help pay your living expenses, then high-yield stocks can be the best way to get the dividend income you need. But income investors who have experience with dividend stocks know that the highest-yielding companies often have skeletons in the closet that make them bad investments.
It wasn't that long ago that even some of the most experienced dividend stock investors had all but written off one popular sector that has traditionally featured some of the highest yields available. Yet although these stocks have largely flown under the radar in recent years, they've avoided the crushing blows that many had expected to see, and there's even reason to think that they could continue to do well in the years to come. The following three mortgage real estate investment trusts (REITs) have extremely high yields, and they've thus far defied doomsayers who had predicted big losses for shareholders.
|
Stock |
Current Yield |
Share Price Change, 3 Years |
Total Return, 3 Years |
|---|---|---|---|
|
Annaly Capital Management (NLY 1.33%) |
11.7% |
(0.3%) |
35.6% |
|
AGNC Investment (AGNC 0.99%) |
11.6% |
(13.7%) |
22.8% |
|
ARMOUR Residential REIT (ARR 2.60%) |
9.9% |
(8.8%) |
34.4% |
Source: Yahoo! Finance.
How mortgage REITs work
Real estate investment trusts are well-known for their high yields, and REITs that specialize in mortgage-backed securities have had particularly attractive dividend yields over the years. The reason: Mortgage REITs borrow extensively in order to generate leverage, getting capital at relatively low short-term rates and then purchasing higher-yield long-term mortgage securities with that money. The difference between the income from their holdings and the payments on their borrowings represents the cash flow that, in turn, funds the big dividend payments that mortgage REITs typically make.
Mortgage REITs work best when short-term rates are much lower than long-term rates and when the overall market environment is relatively flat. That strategy worked amazingly well for companies like Annaly Capital, AGNC Investment, and ARMOUR Residential from 2009 to early 2013 when the fallout from the financial crisis left the Federal Reserve in a position in which it didn't think it could afford to boost short-term rates much without endangering the economic recovery.
Image source: Getty Images.
Why mortgage REITs looked scary
Unfortunately, mortgage REITs are particularly sensitive to the threat of higher short-term interest rates because their extensive levels of leverage can make net income disappear when borrowing costs rise even incrementally. Bond investors had expected the extraordinary measures that the Fed had taken to support the capital markets -- including not only traditional decreases in interest rates, but also special moves like quantitative easing through purchases of longer-term securities -- to come to an end at some point. After several years, the Fed finally signaled that rate increases would be coming and that it would look at ways to unwind the big increase in the size of its balance sheet.
Investors took the Fed's moves as a sign that the bottom was about to fall out of the mortgage REIT market. Companies in the sector took an immediate big hit, with share prices falling 30% to 40% in just a matter of months. When rate hikes actually started to happen and the Fed announced how it would scale back on previous bond purchases, further losses ensued among the highest-yielding names in the industry. Skeptics argued that mortgage REITs were essentially doomed as their business models wouldn't allow them to survive in an environment of rapidly rising rates.
Take the money and run
Yet investors turned out to be wrong about how mortgage REITs would do when rates climbed. As the table near the top of this article shows, share prices have indeed gone down slightly for key mortgage REITs, with AGNC sporting the worst performance with double-digit percentage declines. Even the strongest REIT on the list, Annaly Capital, hasn't been able to avoid the drops in share prices.
Yet the dividends that these companies have paid have turned what would have been poor performance into a solid showing. Gains of 20% to 40% work out to annual total returns of about 6% to 12%. In other words, all it takes for high-yield stocks to turn mild losses into good gains is a double-digit dividend yield to support their shares.
Can the good times last?
Market watchers expect that the Fed will make further moves to tighten monetary policy, and if the difference between short-term and long-term interest rates narrows, then it could hurt income levels for Annaly Capital, AGNC Investment, and ARMOUR Residential. Yet even if small share-price declines ensue, having such vast amounts of income pouring in on a regular basis will go a long way toward offsetting those losses and producing a reliable stream of income for investors in the mortgage REIT space.
