More often than not, dividend stocks are the "X-Factor" that propels the average investment portfolio to greatness over the long run. That's because dividend stocks offer three key advantages that cause investors to seek them out.
The promises and perils of dividend investing
To begin with, dividend stocks are usually beacons of profitability. A company's board of directors would be unlikely to share a percentage of profits with shareholders -- let alone grow the amount being shared over time -- if there wasn't the strong belief that business growth would continue. In other words, dividend stocks tend to be associated with time-tested business models.
Second, dividend stocks offer the perfect way to hedge against inevitable downside in the stock market. There have been 36 corrections of at least 10% in the S&P 500 since 1950, according to data from Yardeni Research. Though a dividend payout is unlikely to negate the entirety of a downside move in the stock market, it can provide a solid hedge that allows investors to stay focused on the long term.
Lastly, and perhaps most importantly, dividends can be reinvested back into more shares of dividend-paying stock. In doing so, you'll have an opportunity to compound your wealth at a much quicker pace. This is the same strategy that money managers often use to increase wealth for their clients.
Of course, dividend investing does have its risks. In theory, investors want the highest yield imaginable with as little risk as possible. Unfortunately, yield and risk can often times go hand-in-hand. That's because dividend yield is a function of a stock's share price. For instance, a company with a floundering business model and a cratering share price may offer an exceptionally high yield, which could lure in unsuspecting investors. Its instances like this that sometimes give high-yield dividend stocks a bad rap.
Mortgage REITs are getting no love from Wall Street
Among this group of oft-questioned high-yielding stocks is the mortgage real estate investment trust (REIT) industry. Mortgage REITs primarily invest in mortgage-backed securities, and they make their money by using interest rates and leverage to their advantage.
Here's how it works: A mortgage REIT will purchase agency or non-agency debt securities -- agency-only securities are backed by the government in case of default, while non-agency debt isn't -- and collect interest on that debt. In turn, these REITs will borrow money at a short-term lending rate, allowing them to lever up and acquire more debt securities in order to pump up their net operating income. The rate at which they earn interest on their debt securities, minus the short-term interest rate they pay, is their net interest margin. This net interest margin is pretty much the holy grail of metrics for investors to follow when analyzing mortgage REITs.
It's also worth pointing out that since these companies operate under a tax-incentivized REIT structure, they're required to pay out nearly all of their income in the form of a dividend in order to avoid being taxed at normal corporate rates. That's why mortgage REIT yields have been near, or above, 10%.
Right now, though, there are seemingly few dirtier words on Wall Street than "mortgage REIT," and that's because of the current rising interest rate environment. As noted above, these are companies that rely on short-term lending rates to lever up. But if interest rates rise, their net interest margins traditionally shrink. If these margins shrink, dividend cuts are often soon to follow. A falling share price and a declining dividend aren't a good recipe for investors.
Ignore the noise: Here's why mortgage REITs should be on your radar
But what if I told you that this time was different, and that some mortgage REITs may well deserve a closer look. Don't believe me? Here are three reasons why I'm fairly confident that mortgage REITs could surprise Wall Street and outperform over the next couple of years.
To begin with, the expediency of interest rate increases from the Federal Reserve does make a difference. The last time the Fed undertook a significant monetary tightening cycle, the fed funds rate rose by 425-basis-points in just 26 months (May 2004 – July 2006). Such a rapid rise in interest rates didn't give what few mortgage REITs existed back then much time to react and adjust their holdings.
However, the pace at which rate hikes are being implemented following the Great Recession is about as slow as it's been since the mid-1960s. Since December 2015, the Fed has hiked its fed funds target rate six times, each by 25 basis points. Though this has indeed tightened the net interest margin for mortgage REITs, it's also given them ample time to adjust their holdings and leverage to minimize this impact as much as possible. That's a key point that a lot of investors appear to be overlooking.
Second, and building on that previous point, what mortgage REITs might lack with a less-than-perfect rising-rate environment, they've gained in managerial experience. With the exception of industry juggernaut Annaly Capital Management (NLY 1.28%), virtually no other mortgage REITs had much experience prior to the Great Recession. However, most of these publicly traded mortgage REITs now have a decade or more of experience under their belts. This experience should come in handy as lending rates rise.
Finally, even under the direst of circumstances, mortgage REITs have generally delivered well-above-average yields. Annaly, following that aforementioned 425-basis-point increase in interest rates, saw its yield decline from north of 12% to just a hair below 4% in about a year. Yet even at a 4% yield, Annaly was delivering far more income than the broader market average. Historically, Annaly has returned about 10% a year to investors over the past two decades. That type of consistent annual income would be tough to beat.
A word to the wise
While I'm relatively confident that mortgage REITs could surprise Wall Street in a good way, I'd also caution investors that no two mortgage REITs are alike, so put away the darts and Ouija board.
In particular, agency-only mortgage REITs tend to be a considerably safer bet during a rising interest rate environment. This would include Annaly Capital Management, which had $90.6 billion of its $101.8 billion in total assets invested in agency mortgage-backed securities (MBS) as of Dec. 31, 2017, as well as AGNC Investment Corp. (AGNC 1.19%), which had $54.8 billion of its $69.3 billion investment portfolio tied up in agency MBSs. Though agency MBSs pay less given that they're protected from default, it allows Annaly Capital Management and AGNC Investment Corp. to lean on leverage to generate income. As of their most recent quarters, Annaly and AGNC sported respective leverage of 6.6-to-1 and 8.2-to-1.
Comparatively, non-agency mortgage REITs do run the risk of default on their debt securities if the U.S. economy takes a turn for the worse. They'd also be at risk if the Federal Reserve picks up the pace at which it raises its fed funds target rate. This isn't to say that non-agency mortgage REITs are 100% off-limits, but extra scrutiny should be given when analyzing them for possible investment.
In sum, if you're looking for high-yield income that could pack a punch, consider digging into mortgage REITs like Annaly Capital Management and AGNC Investment Corp. You may like what you find.