In the current low interest rate environment, income investors have to struggle to find yield. That said, there are good income-paying stocks if you know where to look. Mortgage real estate investment trusts (REITs) are some of the best candidates, often paying double-digit yields. Two of the best mortgage REITs are AGNC Investment (AGNC +1.31%) and Annaly Capital Management (NLY +1.03%). But which among the two is the better candidate?
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Mortgage REITs are different than traditional REITs
Mortgage REITs have a different business model than the traditional REIT, which follows the typical landlord/tenant model. The latter will build an apartment, office, or retail space, and then lease out the units to tenants. They finance the property with long-term, low-interest rate loans, and the difference between the interest they pay and the rent they earn is their profit.
Mortgage REITs buy real estate debt, not real estate itself. Instead of buying buildings, they buy mortgages and mortgage-backed securities. They then use leverage (in other words, borrowed money) to increase the size of their investment portfolios. The difference between the interest they earn and the interest they pay is their profit margin. Their operations are more similar to that of banks than, say, an apartment REIT.
Credit risk versus government guarantees
Both Annaly and AGNC invest primarily in government-guaranteed mortgages, which puts them in the agency REIT bucket. If you recently bought a house, chances are the bank that made the loan sold the loan to Fannie Mae or Freddie Mac. In turn, those agencies probably securitized the loan, and that security may have been bought by one of these mortgage REITs.
Since agency mortgage-backed securities are guaranteed by the government, they have no credit risk. If the borrower fails to make the mortgage payment, investors in these securities still get paid. This means that the basic returns on these securities are low, and the REIT needs to use more leverage to turn a bunch of securities paying 3% into an 8% dividend yield. Here is how it works. A REIT has a million dollars in equity, which it could invest in a mortgage backed security paying 3%. Conversely, it could take out a repurchase loan which allows it to borrow another 5 million, provided it posts the mortgage backed securities as collateral. Now the REIT is earning 5 times that 3% on the same equity. It has to pay interest, but the rate on those loans is much lower than what it earns on the security. This is how these fat dividends get built up.
While Annaly and AGNC are classified as agency mortgage REITs, they both carry some credit risk.
However, Annaly holds about 27% of its portfolio in products that do bear credit risk, which is much higher than AGNC. These include mortgage-backed securities that are not backed by the government, middle-market loans, and mortgage servicing rights. If a security has higher risk, it generally pays a higher return, and you can see the evidence below. If you look at the table below, you'll see that Annaly has a higher net interest spread and a lower debt-to-equity ratio, yet pays a higher dividend. More risk equals more return.
| Dividend Yield | Price to Tangible Book | Net Interest Spread | Debt to Equity Ratio | |
|---|---|---|---|---|
| Annaly Capital | 9.7% | 101% | 3.39% | 5.1 |
| AGNC Investment | 8.1% | 101% | 2.00% | 6.5 |
Data source: Company filings.
The decision hinges on your economic outlook
The big question for investors is the overall economic environment. If we are heading into good economic times, then taking credit risk makes sense. If we are heading into a recession, then perhaps the safety of government-guaranteed assets makes more sense. The consensus seems to be that we should see a robust expansion this year as the economy recovers from COVID-19.
Annaly pays an annualized dividend yield of 9.7%, which is certainly higher than AGNC's 8.1% yield. Both Annaly and AGNC cut their dividends last year in the early days of COVID, and AGNC admitted later that it might have not been necessary. AGNC recently returned to pre-COVID levels and a dividend hike is probably in the cards. This will probably equalize the two stocks' dividend yields, and historically they have pretty much been the same.
For investors, it comes down to the economic view. If you think the economy will continue to expand and we are heading into a long period of above-average growth, then Annaly's portfolio will probably outperform AGNC's. On the other hand, if you think the current economic boom is a "sugar high" (in other words, the result of government stimulus and temporary pent-up demand and will peter out), then perhaps AGNC is the better bet. Either way, both companies are high-quality mortgage REITs and good candidates for income investors.
