However, because mortgage real estate investment trusts can be volatile investments, choosing the right stock is essential to earning a consistent return. By digging into each company's strategy for creating income and managing risk I'll determine whether ARMOUR or Invesco Mortgage is the better dividend stock for your portfolio.
Both companies manage a portfolio of longer-term mortgage-related assets funded by short-term borrowing, earning the difference between the cost of borrowing and the yield on assets. Beyond that, ARMOUR and Invesco Mortgage are very different.
ARMOUR Residential REIT
Because ARMOUR invests exclusively in "agency" mortgage-backed securities -- pools of residential mortgage debt packaged by Fannie Mae and Freddie Mac -- its assets are low-yielding and guaranteed against default.
While this sounds pretty vanilla, and it is, ARMOUR can magnify its returns using leverage. This involves using borrowed funds to grow assets, and the more debt the company takes on compared to equity the greater the risk and reward. With a leverage ratio of 7.9:1 -- meaning for every $1 of equity it has $7.90 of debt -- ARMOUR has one of the highest leverage ratios among agency mREITs.
For companies outside the financial sector, high leverage is a red flag. However, with a net interest margin of 1.46% -- the difference between borrowing costs and assets yields -- it's the most effective way to generate a greater return on equity.
Invesco Mortgage Capital
Far from vanilla, Invesco Mortgage Invests in a much wider variety of assets. Below is a breakdown of the company's portfolio.
Invesco Mortgage invests about half of its portfolio in agency securities and half in a more diverse group of residential and commercial assets not guaranteed against default. Keep in mind that while some of these assets can default, it doesn't mean they will default. For instance, prime and Alt-A -- which make up the majority of Invesco Mortgage's "nonagency RMBS" -- are of stronger credit-quality than their less reputable "subprime" cousins.
Equally important, Invesco Mortgage's leverage ratio of 7:1 is significantly higher than fellow nonagency mREITs -- though it is somewhat less alarming considering that the majority of its assets are of higher quality than similar nonagency mREITs.
Despite holding different assets, the risks for ARMOUR and Invesco Mortgage are similar. Among the most important of those risks is liquidity. By posting collateral mREITs receive lower-cost funding, but if the value of collateral falls -- which can happen for myriad reasons -- the lender can issue a "margin call," or ask the borrower to pay back the loan early or post additional collateral.
Here's where things get interesting: A company that doesn't have the available liquidity to meet the margin call will need to sell securities -- if able to -- which can lead to significant losses, or worse.
ARMOUR Residential REIT
Rising long-term interest rates could lower the market value of ARMOUR's collateral, and it's possible it could see margin calls. However, the company manages some of this risk by investing in shorter-duration assets and using interest rate swaps -- a derivative contract that allows mREITs to lock in funding costs. Moreover, ARMOUR is holding about four times as much cash as Invesco Mortgage, owns only high-quality and very liquid agency securities, and is, ultimately, in a strong liquidity position.
Invesco Mortgage Capital
Invesco Mortgage might not be in quite as strong a position as ARMOUR, but its diverse asset base helps protect the company from risk. For instance, rising interest rates lower the market value of agency securities, but nonagency assets will be less affected. And when the mortgage market experiences an increase in defaults, agency securities perform better. In essence, Invesco Mortgage's portfolio has the best of both worlds, and this has the potential to smooth out returns over time.
The tale of two dividend stocks
While the idea of a "safe mREIT" is a bit of an oxymoron, by investing solely in high-quality assets and preparing its portfolio well for rising interest rates, I think ARMOUR is the safer option. With that said, there is a fine line between strong risk management and playing so much defense the company can't create reasonable returns.
For that reason, I find myself more attracted to Invesco Mortgage. The company might target riskier assets with high leverage, but if the housing market continues to progress these assets should yield attractive returns while protecting the company from the more imminent threat of rising interest rates -- which the Federal Reserve has suggested will likely increase around mid-2015. Ultimately, for investors willing to take on some risk, I believe Invesco Mortgage has more weapons to help maintain its dividend, and is therefore the better dividend stock.
Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.