Although the stock market is two months removed from what was its largest swoon in years, the brief increase in volatility in October served two key purposes. It reminded investors that the stock market doesn't, in fact, go up forever, and it gave smart investors a kick in the keister reminder that owning dividend stocks is good way to mitigate their downside when stock market uncertainty is on the rise.
Dividend stocks are a critical component of any well-run portfolio, especially when they are reinvested back into the same stocks. They serve as a foundation for long-term investors since companies with sustainable business models are the most likely to pay a regular dividend.
Generally speaking, the higher the dividend yield the more attractive a stock might appear to an income investor. While that might be true if the dividend payment is rock-solid and unlikely to change, high-yield dividends can also be a trap for some investors. If investors don't truly understand the business behind the dividend they could be buying into a dicey situation that ultimately leads to a dividend cut.
Woe is the mortgage REIT industry
One such industry that's witnessed its fair share of dividend cuts over the past five years are mortgage real estate investment trusts, or mREITs. These are companies that purchase mortgage-backed securities and other investments, some of which might be backed against default by the government (known as agency loans) and some which aren't backed by the government (non-agency).
As you might imagine, agency and non-agency loans have their own set of benefits and downfalls. Agency loans are extremely safe since they're backed by the government in case of default, but their yields are often notoriously low, especially with interest rates as low as they are right now. But, agency loans also allow mREITs to use their leverage to add to their profits. On the other hand, non-agency loans have much juicier yields, but as you might have guessed since they aren't backed by the government, any defaults experienced on these loans fall directly back onto the mREIT in question.
Traditionally speaking, mREITs perform the strongest when lending rates are falling. After many years of near record-low lending rates, and the expectation that the Federal Reserve will move its federal funds target rate higher in 2015, profit forecasts and margins have been falling for the entire sector. And, since REITs are required to pay out 90% or more of their profits in the form of a dividend, it means their payouts have been steadily dropping as well.
Ignore these high-yield dividend stocks and you might regret it
The circumstances surrounding the mREIT industry at the moment definitely aren't ideal, but investors have pummeled these companies to the point where overlooking them here might be something you regret in five to 10 years.
A majority of non-agency-invested mREITs, for example, have reduced their non-agency holdings in favor of beefing up their agency holdings. In the short-run this reduces their net interest margin, but it sets these companies up for longer-term success by reducing risk. Chimera Investment (NYSE:CIM), based on its third-quarter results, greatly added to its agency RMBS portfolio while adding only a minimal amount to its non-agency portfolio. Although its net interest rate spread sank by 136 basis points, Chimera's portfolio looks much more stable, and the company seems likely able to maintain its current $0.09/quarter payout at least in the intermediate term.
By a similar token, investors are also forgetting that historically the mREIT sector has paid out government bond-topping yields. As you can see from the above dividend yield statistics, each of the mREITs shown is currently paying out 10.5% or better, including ARMOUR Residential REIT (NYSE:ARR) with its 15.5% yield. Even if you include the record-low interest rate environment since 2009, Annaly Capital Management (NYSE:NLY) has yielded an average of 10% over the past 15 years. Assuming an investor began with $10,000 and reinvested their dividends for 15 years they would, without any stock appreciation whatsoever, have close to $42,000!
Lastly, investors should consider that the Federal Reserve's vision of where its target lending rate will be a few years from now is considerably lower than where lending rates were back in 2005-2007.
With an effective federal funds rate of just 0.09% as of November, the Fed is estimating a rate of just 2.88% by 2016. This is still historically low as you can see above, and would be conducive to relatively stable yields based on the asset moves most mREITs have made in recent quarters.
In short, feel free to overlook the mREIT industry, but in doing so you give up the potential to earn what could be market-topping gains over the long run.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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