Are These Dividend Stocks in Trouble?

The market's highest-yielding dividend stocks are easy to love. Not only do they pad shareholders' pockets each quarter, but they also generally carry less risk than their non-dividend paying brethren. It's partly for these reasons that Fool Dan Dzombak's high-yield portfolio is beating the S&P 500 by almost 12 percentage points.

As we've seen over the last year, however, certain high-yielding stocks can nevertheless wreak havoc on an investor's portfolio. And mortgage REITs in particular have been some of the worst offenders. In an article about the 10 worst mREITs of 2011, for example, Fool analyst Anand Chokkavelu exposed mREIT stocks that produced sizable negative returns despite often offering huge dividend yields.

To see why this is so, and to help predict what's in store for these stocks going forward, we'll take a look at the biggest threat facing these monster dividend payers in 2012.

mREITs and interest rate risk
Mortgage REITs are leveraged investment funds that invest either directly in real estate or indirectly via mortgage-backed securities and collateralized mortgage obligations. They make money by borrowing capital at low short-term interest rates and then lending it out at higher long-term rates. The difference between the two, illustrated in the table below, is known as the interest rate spread.

Source: S&P Capital IQ, as of most recent quarterly data.

While it may seem ironic given the condition of the real estate market since 2008, these funds have done particularly well for most of the intervening time period. The reason for this is that their borrowing costs have dropped to near-historic levels, courtesy of the Federal Reserve's efforts to revitalize the economy by decreasing short-term interest rates.

Annaly's cost of borrowing provides a perfect example. Its average cost of interest-bearing liabilities has decreased by a staggering 60% since the second quarter of 2008, going from 4.18% down to 1.63% in the third quarter of 2011. Meanwhile, its average yield on interest earning assets decreased by only 34% over the same time period, going from 5.64% down to 3.71%. Annaly's interest rate spread increased in kind, going from 1.46% in the second quarter of 2008 up to 2.68% in the third quarter of 2011, an increase of 46%.

The issue now, however, is that the Federal Reserve appears intent on lowering long-term interest rates -- particularly those that affect the housing market. William Dudley, president of the Federal Reserve Bank of New York, addressed this in a recent speech before a New Jersey bankers group: "The ongoing weakness in housing has made it more difficult to achieve a vigorous economic recovery . . . With additional housing policy interventions, we could achieve a better set of economic outcomes." And these comments come after Federal Reserve Governor Daniel Tarullo called on the central bank to initiate another round of quantitative easing targeted at mortgage-backed securities. According to The Wall Street Journal, the idea is to push mortgage rates downward to encourage more home purchases and to spur refinancings that could provide homeowners with cash to buy other goods.

While lower long-term interest rates are great for homeowners, as they translate into lower mortgage rates, they're anathema to an mREIT like Annaly, which relies on the interest rate spread to make money and thereby pay its monster dividend. I believe it was this fear that led investors to bid down the price of mREIT stocks in 2011. Even including Chimera's and Invesco's double-digit dividend yields, for example, both stocks ended the year down by more than 20%. And the remaining three companies in the table above -- American Capital Agency, Annaly, and Armour Residential -- all saw the price of their shares decline.

What to expect from 2012?
As I've discussed before, I'm extremely bearish when it comes to mREITs over the near- to mid-term future. I believe current economic realities -- principally the unemployment rate -- and the new composition of the Fed's monetary policy committee make it highly likely that the central bank will move to decrease long-term interest rates. This would eviscerate mREITs' profits and force them to further reduce their dividend payouts, which will have the corresponding effect of decreasing the price of their shares. And while I could be wrong, I see this as a probability and not a possibility.

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