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Is There Danger Ahead for These 2 High-Yield Dividend Stocks?

By Brent Nyitray, CFA – Aug 18, 2021 at 10:15AM

Key Points

  • The Fed's support for the mortgage market will begin to fade.
  • The last time the Fed removed support, mortgage REITs got clobbered.
  • The industry might have learned some lessons from the "taper tantrum."

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Will history repeat itself?

There is an old market saying that goes, "Don't fight the Fed." It generally means that stocks tend to struggle when the Fed is raising rates and tend to rally when the Fed is cutting them. Although it is generally not a good idea to exit the market when the Fed is raising rates, it does mean that some sectors will do better than others in that kind of environment.

This brings us to the mortgage real estate investment trusts (REITs), especially the leaders in the sector: Annaly Capital Management (NLY -0.41%) and AGNC Investment (AGNC -0.60%).

Picture of the Federal Reserve Building

Image source: Getty Images.

The Fed's behavior in the markets can help or hurt mortgage REITs

The Fed has a dual mandate, which is to manage inflation while maintaining maximum employment. This means that the Fed will try to hold down rates when the economy is struggling, and raise them during a recovery. In addition, the Fed has been purchasing Treasuries and mortgage-backed securities in the market, driving down longer-term interest rates and boosting the value of bonds and other fixed-income securities. While the Fed has been pretty direct in saying it is nowhere close to increasing interest rates, it is beginning to discuss when to stop or slow its purchases of Treasuries and mortgage-backed securities.

The Fed has been buying $40 billion of agency mortgage-backed securities a month since the early days of the pandemic. These securities are the same type that Annaly and AGNC Investment hold, and that buying activity helps boost the value of their portfolios.

Here is how the mortgage-backed securities market works: Mortgage-backed securities come from mortgage originators like Rocket and UWM Holdings, which make loans and securitize and sell them into the market. The buyers of these mortgage-backed securities are professional money managers such as pension and bond funds, mortgage REITs, and the Fed. The Fed has absorbed a lot of the mortgages, and this has helped keep rates low. The concern for the mortgage REITs is that the biggest buyer of mortgage-backed securities is going to reduce its purchases. Once this happens, the value of these securities will weaken, and that will drag down the value of the mortgage REIT sector. 

A trip down memory lane to the "taper tantrum" of 2013

We do have a historical record of how mortgage REITs performed the last time the Fed contemplated reducing purchases, which was dubbed the "taper tantrum" of 2013. During 2013, the Fed hinted at cutting Treasury and MBS purchases and ended up announcing its first reduction at the December 2013 open market committee meeting, saying it was cutting its monthly purchases from $85 billion to $75 billion.

Take a look below at the chart of how Annaly and AGNC performed during 2013. While there was discussion of reducing purchases, the most direct hint came during former Fed Chair Ben Bernanke's Congressional testimony in May 2013: "If we see continued improvement and we have confidence that that's going to be sustained then we could in the next few meetings ... take a step down in our pace of purchases," Bernanke said. You can see how Annaly and AGNC reacted -- they were clobbered. 

AGNC Chart

AGNC data by YCharts

While the Fed didn't announce a reduction in purchases until the end of the year, mortgage-backed securities began to underperform Treasuries after that statement. The industry vernacular is that "mortgage-backed security spreads widened," which really just means that the difference in yield between Treasuries and mortgage-backed securities increased. In practical terms, it means that the portfolios of Annaly and AGNC underperformed. This led Annaly to cut its  dividend during 2013 from $0.45 per share to $0.30, while AGNC Investment cut its dividend from $1.25 to $0.65.  

Mortgage REITs and the Fed have learned from the experience of 2013

The Fed has acknowledged that it didn't handle things perfectly in 2013, and it wants to ensure that we don't see a repeat. While the Fed may indeed stick the landing and manage to extricate itself from the mortgage-backed securities market without causing too much disruption, a repeat of 2013 is certainly a possibility, and we have already begun to see widening spreads.

Both Annaly and AGNC reported declines in book value per share on their second-quarter earnings calls. Annaly is probably in a little bit better shape than AGNC because it has other investments that will be less sensitive to mortgage-backed security spreads. Both companies also have the institutional knowledge of that period, so presumably they will be better prepared this time around. The bottom line is that changes in Fed policy present a risk for mortgage REITs and investors should keep that in mind. 

Brent Nyitray, CFA has no positions in the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

Stocks Mentioned

Annaly Capital Management Stock Quote
Annaly Capital Management
NLY
$21.79 (-0.41%) $0.09
AGNC Investment Corp. Stock Quote
AGNC Investment Corp.
AGNC
$10.01 (-0.60%) $0.06
Rocket Companies, Inc. Stock Quote
Rocket Companies, Inc.
RKT
$8.41 (-1.52%) $0.13
UWM Holdings Corporation Stock Quote
UWM Holdings Corporation
UWMC
$4.47 (2.52%) $0.11

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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