With interest rates stuck near zero, investors seeking income are struggling to find yield. There are really only a dozen or so stocks in the S&P 500 with dividend yields above 6%. At the moment, they're concentrated in either the real estate space or the energy sector. Today, we'll look at a couple of real estate stocks that invest in securities guaranteed by the U.S. government.
Some of the best yields are found in the real estate investment trust (REIT) space. REITs are required to distribute most of their earnings in the form of dividends, which makes them great holdings for investors who are looking for current income.
REITs generally fall into the landlord/tenant model. They'll build a property -- for example an office or apartment building -- and then rent out the units to tenants. Most of the biggest REITs have yields in the 4% range; however, there's a subset that yields more, and those are the mortgage REITs.
Mortgage REITs don't own properties -- they own property debt (in other words, mortgage-backed securities). If you recently refinanced your home, chances are that your lender sold the loan to a mortgage REIT.
Agency REITs mainly own securities guaranteed by the U.S. government
AGNC Investment Corp. (AGNC 0.34%) is an agency mortgage REIT, focusing on mortgage-backed securities that are guaranteed by U.S. government agencies (hence the term "agency"). If the borrower is unable to make the principal and interest payments for the mortgage, someone will make it for them, ensuring the investor gets paid the interest and principal on time.
AGNC buys mortgage-backed securities and then uses leverage (borrowed money) to increase the potential return. This is how it turns a bunch of mortgages that pay 3% into a fatter yield. The amount it earns on the mortgage portfolio is about 2% higher than the amount it pays on the debt to finance the portfolio.
AGNC pays a monthly dividend of $0.12, which gives the stock a yield of 8.8% at Tuesday's closing price. It also trades at a small discount to tangible book value per share. AGNC rewards shareholders with a strong dividend yield, as well as a stock-buyback program.
When a mortgage REIT is trading below book value per share, it can increase book value simply by buying its own shares at a discount to book. Since mortgage REITs generally trade right around book value per share, this can help provide a secondary wind at the backs of shareholders.
Annaly Capital Management (NLY 0.80%) has a similar business model to AGNC. Annaly primarily owns mortgage-backed securities that are guaranteed by the U.S. government, but it also makes loans to middle-market companies and buys mortgage loans that are not guaranteed by the U.S. government. While Annaly takes more credit risk than AGNC, it's still mainly invested in agency mortgage-backed securities. If you think that the U.S. economy is going to take off in the second half of the year, then Annaly might be an interesting investment, as credit-sensitive assets might outperform.
Annaly pays a quarterly dividend of $0.22, which works out to a dividend yield of 10.6%. Like AGNC Investment, Annaly trades at a 7% discount to book value, and the company has been buying back stock.
Despite government guarantees, liquidity risk can be an issue
The mortgage REIT sector struggled about a year ago as interest rates fell and liquidity dried up in the mortgage-backed securities markets. The drop in mortgage asset prices caused a wave of margin calls for the entire sector. No stock was spared, and they all sold off assets and cut their dividends.
This illustrates the one risk that's impossible to hedge: liquidity risk, which is the inability to quickly turn an asset into cash. This is the biggest risk with owning mortgage REITs.
In periods of financial stress, these stocks can be subject to margin calls, which force them to sell assets at less-than-favorable prices. That said, government-guaranteed mortgage-backed securities are the most stable, and both of these stocks concentrate their portfolios there.