One of the worst-performing sectors this year is the one associated with mortgages. Mortgage originators saw major declines in origination volumes as rising interest rates removed the consumer's incentive to refinance. Mortgage real estate investment trusts (REITs) have also been beaten down this year as interest rates have increased.
Investors looking at the sky-high dividend yields on mortgage REITs should be careful.
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Mortgage REITs are unlike most REITs
AGNC Investment (AGNC 1.85%) is a mortgage REIT, which differs from a typical REIT. Most REITs follow a landlord/tenant business model, where the REIT develops properties and then leases them out. Mortgage REITs don't invest in physical real estate, they invest in real estate debt (i.e., mortgages). In many ways, their business model is similar to a bank. Mortgage REITs like AGNC Investment will borrow money and invest in mortgage-backed securities, which contain thousands of individual mortgages. If you recently bought a house and you used a mortgage loan guaranteed by Fannie Mae or Freddie Mac, chances are it ended up in a mortgage-backed security, which might be held by a mortgage REIT.
AGNC Investment concentrates almost entirely on mortgage-backed securities which are guaranteed by the U.S. government. This means that AGNC doesn't bear credit risk. It knows with certainty that it will get paid back its principal. AGNC might not bear credit risk, but it bears a lot of interest rate risk, and this is the issue with the whole sector. Volatility in interest rates causes mortgage-backed securities to be worth less.
In other words, the ideal environment for a mortgage REIT would be a long period of unchanging interest rates. Ever since the Federal Reserve began hiking the federal funds rate, we have seen outsized volatility in the bond market. This has been amplified by fears that the Fed will begin to sell its portfolio of mortgage-backed securities, which could increase the appetite for mortgage-backed securities and make them cheaper.
Underperforming mortgage-backed securities have been an issue
AGNC doesn't make interest rate bets. It tries to ensure that its portfolio is hedged if rates go up or down. The problem for mortgage-backed securities has been that they have underperformed their hedges. This means that the hedges haven't earned enough money to offset the losses on the mortgage portfolio. In trader parlance, mortgage-backed security spreads have "widened" -- the mortgage REITs are seeing consistent declines in book value per share. While wider spreads mean higher income going forward, in the near term, they mean higher risk for a dividend cut.
Mortgage-backed security spreads widened considerably over the past few months as investors increase their forecast of the projected federal funds rate later this year. This means that investors in the mortgage REIT space should brace for declines in book value per share. If you look at AGNC Investment's historic dividend yield, it is quite high. We saw dividend cuts in 2015 and 2020, so when the dividend yield gets in the high teens, it is too good to be true.
AGNC Dividend Yield data by YCharts
Wait until the Fed finishes its tightening cycle
As a general rule, mortgage REITs have the highest dividend of the REIT sector. This is because they tend to use a lot of leverage. High dividend yields in this sector are not like double-digit yields in, say, the banking sector or the tech sector. A double-digit yield in either of those is usually too good to be true. AGNC Investment will probably become investible once the Fed has finished hiking rates, likely late this year or early next year. Until then, it is a highly risky stock.
