Income investors should keep the mortgage real estate investment trusts (REITs) on their watch lists. These under-the-radar companies are offering some of the best dividend yields out there right now. Earlier this year the sector was battered by margin calls as the bond markets lurched in response to the early days of the COVID-19 crisis. While some stocks in the sector had what could only be called near-death experiences, the agency REITs held up better than the others.

The two biggest agency REITs are Annaly Capital and AGNC Investment. Which one is the better choice for investors? Let's take a look.

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Mortgage REITs are a different animal than the typical REIT 

For those who aren't familiar with mortgage REITs, they have a different business model than traditional REITs, which invest in physical real estate and charge rent (such as apartment REITs, office REITs, and retail REITs). Traditional REITs' earnings are driven by the difference between the cost of financing and the rents earned, after expenses. This year has been rough for most REITs, as many of their tenants have struggled. The mall REITs have probably been hit hardest. 

Mortgage REITs don't own property or charge rent. Their business model involves investing in real estate debt securities, and their earnings are driven by the difference between the interest they receive on their assets and the interest they pay on financing these assets. AGNC and Annaly are referred to as agency mortgage REITs because they invest mainly in "agency mortgage-backed securities," which are packages of mortgage loans guaranteed by the U.S. government. Chances are that your mortgage (if you have one) ended up in an agency mortgage-backed security like the ones these companies hold.

Mortgage REITs that take no credit risk can still be risky

Since agency mortgages are guaranteed by the government, the holders bear no credit risk. If the borrower stops paying, the government will ensure the investor gets the interest and principal owed. This means that the interest rates on these assets are generally low, so the companies have to borrow a lot of money to earn a return. This doesn't mean agency REITs are immune from financial stress. Earlier this year, the entire mortgage REIT sector was buffeted by volatility in the bond market and forced to sell assets in a declining market to meet margin calls. They all reported declines in book value and cut their dividends. So it is important to keep in mind that "no credit risk" does not mean "no risk."

Both companies are trading at similar valuations

Given that Annaly and AGNC have very similar business models, their most important statistics are pretty similar. Annaly has a higher dividend yield and has a smaller discount to book value. The net interest margin (the difference between what a company earns on its investment portfolio less the interest it pays on its debt) is in the low 2% range. Annaly and AGNC both have a small amount of credit exposure, but it is small as a percentage of the investment portfolio. AGNC has a smaller yield, but it has a bigger discount to book value. Annaly has a little less leverage, and a slightly smaller net interest margin. Annaly also has a touch more credit exposure, which means it holds some assets that are not government guaranteed. 

  Dividend Yield Discount to
Book Value
Net Interest
Annaly Capital (NYSE:NLY) 11% 8.4% 2.10% 5.3
AGNC Investment (NASDAQ:AGNC) 9.5% 9.4% 2.15% 5.8

Source: Company filings.

Investors really can't go wrong with either stock. Both are well-run companies with respected management. While both were buffeted by the early days of COVID-19, they held up the best in the sector.

Both companies cut their dividends this year, although Annaly reduced its dividend by only 12%, while AGNC cut its payout by 25%. AGNC said on its second-quarter earnings call that the dividend cut ended up being unnecessary. Given that both trade with similar numbers, it really is hard to say one is a better buy than the other.

Annaly has a bit more credit risk and a higher dividend yield, so it probably gets the nod, although I wouldn't rule out a dividend hike by AGNC. Maybe Annaly's higher yield gives it the edge, but it is close. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.