If there is one sector that has been out of favor for the past few years, it has been the mortgage real estate investment trusts (REIT). Between the COVID-19 pandemic, a massive refinancing wave, and rising rates, the sector has endured an incredibly difficult environment. That said, it looks like some of the headwinds that have bedeviled the sector are beginning to abate. AGNC Investment (AGNC -1.86%) and Annaly Capital (NLY -1.72%) are two leading mortgage REITs with double-digit dividend yields that are worth considering.
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Mortgage REITs are a different animal
Mortgage REITs are different from the typical REIT that invests in properties and collects rent. Those companies have a pretty easy-to-understand business model. Mortgage REITs generally don't buy real estate; they buy real estate debt (in other words, mortgage-backed securities). Instead of collecting rent, they collect interest. The difference between the interest they earn on their securities and what it costs them to borrow is their profit. Mortgage REITs generally look more like banks than the typical REIT.
The Federal Reserve has been a problem for the mortgage REIT sector
Even since inflation became apparent at the end of 2021, longer-term interest rates have been marching steadily upward. The Federal Reserve has been raising the federal funds rate to bring inflation under control, and certain market-based indicators like the fed funds futures are predicting that the central bank is near the end of this tightening cycle. This is welcome news to the mortgage REIT sector.
Mortgage-backed securities have been battered by rising interest rates, the prospect of the Fed selling off its huge fixed-income holdings, and elevated volatility in the bond market. Longer-term interest rates have stabilized and begun to fall as it looks as if the the U.S. could be entering a recession.
The Fed has begun to reduce its portfolio of mortgage-backed securities very gradually, choosing to reinvest only a portion of its maturing mortgage-backed securities back into the market. In addition, mortgage origination volume is down roughly half from where it was last year at this time, so the supply and demand situation is much better than anticipated.
AGNC Investment will be well insulated if we enter a recession
AGNC Investment is known as a mortgage REIT that invests almost exclusively in mortgage-backed securities which are guaranteed by the U.S. government. In other words, if the borrower defaults on his or her mortgage, AGNC Investment will still get its principal and interest payments on time. The company recently reported another drop in book value per share and is cautious about its outlook. However, it sees the valuations of mortgage-backed securities as attractive. If we head into a recession and unemployment rises, AGNC is protected since its payments are government-guaranteed. In addition, it is unlikely that rates will fall so much that borrowers will have an incentive to refinance. AGNC has maintained its monthly dividend of $0.12 per share since the early days of the pandemic and at current levels yields 11.7%.
Annaly has exposure to the fastest-growing sector in the mortgage market
Annaly is another mortgage REIT. However, it has a more diversified portfolio than AGNC Investment. Annaly invests in agency mortgage-backed securities as well as in mortgage-servicing rights and mortgages that are not guaranteed by the U.S. government. Mortgage-servicing rights are an unusual asset in that they increase in value as rates rise, which is helpful for the company if rates continue to work higher. Second, mortgages that do not fit the parameters for a government guarantee are the fastest-growing sector in the mortgage market, and Annaly is one of the leaders in this activity. The Federal government has been looking to reduce its footprint in the mortgage market, and Annaly is poised to benefit from this change. Like AGNC, Annaly has been reporting decreases in book value per share. However, stability in interest rates will go a long way toward stabilizing book value. At current levels, the stock yields 13.3%.
