This article is part of our Rising Star Portfolios series. You can read about the Dada Portfolio here.

The enormous dividend yields residential mortgage REITs offer right now has made them a tempting target for yield-hungry investors.

In fact, the real-money Dada Portfolio I co-manage has bought shares of Annaly Capital for its juicy yield. For us, owning mortgage REITs is a short-to-medium-term play and hedge on a difficult economy.

As the Federal Reserve holds its overnight interest rate to close to 0% to combat high unemployment and low inflation, REITs' funding costs have fallen through the floor. Residential mortgage REITs borrow cheap, short-term loan funds, which they use to buy higher-yielding, longer-term mortgage-backed securities. The profit margin between their borrowing costs and interest income -- known as the interest rate spread -- is relatively wide today. Hence those massive dividend yields.

The 10 highest-yielding REITs
I've put together a table comparing the 10 highest-yielding REITs, so you can compare how individual companies generate their respective dividend payouts. Notice how some (Invesco, Two Harbors, and Chimera) produce abnormally high interest rate spreads, while others utilize greater leverage to boost their returns.

Roughly speaking, higher interest rate spreads suggest the use of riskier, non-Federally guaranteed loans that are subject to potential default from borrowers, whereas higher leverage can juice returns from safer loans but can put a portfolio at greater risk to future interest rate increases.

I've also included trailing book value growth to give you a sense of which managers avoid diluting shareholders during those relatively frequent REIT capital raises. (As the current mortgage REIT boom has led to a proliferation of new companies, not all have five-year histories.)

Company

Dividend Yield

Interest Rate Spread, 2010

Debt-Equity Ratio

5-Year Book Value Per Share Growth

Price-to-Book Value

Cypress Sharpridge (NYSE: CYS)

     19.2%

     2.15

5.5

-

     1.06

American Capital Agency (Nasdaq: AGNC)

     19.0%

     2.33

6.6

-

     1.14

Invesco Mortgage (NYSE: IVR)

     17.6%

     3.63

3.7

-

     1.07

Two Harbors Investment (NYSE: TWO)

     14.9%

     4.70

 3.8

-

     1.08

Chimera Investment (NYSE: CIM)

     14.5%

     4.90

1.8

-

     1.12

Hatteras Financial (NYSE: HTS)

     14.0%

     2.26

6.1

-

     1.09

Anworth Mortgage

     14.0%

-

      

7.5

    

(7.0%)

     1.03

Annaly Capital (NYSE: NLY)

     13.9%

     2.08

6.3

7.0%

     1.13

Capstead Mortgage

     12.6%

     1.74

8.7

7.0%

     1.07

MFA Financial

     11.6%

     2.47

2.9

(1.0%)

     0.99

Source: Capital IQ, a division of Standard & Poor's. Includes companies valued at more than $500 million.

While REITs are enjoying fat spreads on portfolios primarily comprised of Federally guaranteed mortgages, which they lever up considerably, Chimera (which is managed by Annaly Capital) has a more daring operational model: It buys primarily riskier mortgages, which generates a higher spread but forces management to be more conservative with leverage. About 80% of its portfolio is junk or unrated. That said, management appears somewhat bearish on housing and is treading carefully so it can pounce if mortgage-backed security prices decline further.

We'll be increasing our REIT holdings to create a high-yield hedge should the recovery remain sluggish, as we generally expect it to. We'll do so by opening a position in Chimera and buying more shares of Annaly because we like management for its long and successful track record and insightful commentary.

The biggest risk is that the Fed could raise short-term interest rates in response to inflation fears. This would increase borrowing costs -- cutting into profits and causing investors to flee for the exits. In 2005, after one and a half years of gradual rate increases, the Fed Funds rate rose from 2.25% to 4.25%. Annaly's net income fell from a then-record $250 million to a $9 million loss, and shares plunged nearly 50%.

Despite headlines insisting on looming inflation, we believe unemployment remains the greater danger in today's economy and that we still have at least a year or two before the Fed begins to raise rates and probably longer before rates increase in earnest. So we're buying another $500 of Annaly and $300 of Chimera for total position sizes of 6% and 2%, respectively.

If you'd like to stay up to speed on the top commentary and analysis on Annaly and Chimera or any other stock you're interested in, click here to add them to your watchlist. You'll get free, personalized updates on companies you are interested in. You can follow the Dada Portfolio on our discussion board or Twitter @TMFDada.

At the time of publication, Ilan Moscovitz didn't own shares of any company mentioned. The Motley Fool owns shares of Annaly Capital Management. 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.