Stay Away From This 25% Dividend Yield

When something sounds too good to be true, it usually is.

I recently came across a stock with a 25% dividend yield -- great, right? A little digging convinced me to pass on this stock. Read on to find out what the stock is, why you should stay away from it, and another high yielding stock for your consideration instead.

High yield
If you know something about high-yield stocks, you may have guessed that the 25%-yielding stock is a mortgage REIT (mREIT). You'd be partially correct.

For those unfamiliar, mortgage REITS are real estate investment trusts that make money by buying mortgage-backed securities and collecting the interest. If you've looked at mortgage rates recently, you'll realize that investing in mortgages on their own doesn't return much. With the Federal Reserve buying billions of dollars of mortgages every month, mortgage backed securities return just 1%-1.5%.

To boost these returns, mortgage REITs borrow heavily to increase the amount of mortgages they can buy. This enables them to pay out the large dividends that investors love. The important thing for mortgage REIT investors to track is the spread between the return on the bonds and the cost of the money mREITs are borrowing, as well as the mortgage REIT's total level of borrowing compared to its equity.

Source: Capital IQ.

The stocks have been supported by investors' unquenchable thirst for dividends; however, there are two things mREIT investors should worry about.

First, mREITs have huge amounts of debt. Whenever you are investing using huge amounts of debt, small miscalculations or deviations from the expected can cost you everything. Also, a rise in interest rates, while not likely till 2014, would potentially wreak havoc on companies reliant on debt.

Second, the spreads mortgage REITs earn are declining, and the safest yields are under further threat from government action. That means smaller dividends going forward.

Spreads are declining because of Operation Twist, the Federal Reserve's $40 billion per month purchase of mortgage-backed securities (eerily similar to our 2010 April Fool's joke). In this program, the Fed borrows money by selling short-term bonds and uses it to buy long-term MBSes. This greatly increases demand for MBSes, pushing down the interest rates they pay.

Spreads are under further threat as current head of the Federal Housing Finance Agency, Edward DeMarco, may be on the way out. This is a potential problem for some of the largest mREITs in that Demarco was strongly against the Treasury using funds to reduce principal on underwater mortgages, which the Obama administration and Treasury Secretary Tim Geithner were very much for. Refinancing underwater mortgages would be a problem for the mREIT industry as this would open huge amounts of previously unrefinanceable mortgages to refinancing. Refinancing is bad for mREITs as previously issued, higher-than-current interest mortgages get paid off and replaced with lower yielding mortgages, eating into mREITs spreads.

25% yield
So how do you get a 25% yield from a mortgage REIT?

Just add more debt. Seriously.

In October, UBS launched the ETRACS Monthly Pay 2x Leverage Mortgage REIT ETN (MORL +0.00%). Similar to an ETF, an ETN, or exchange traded note, borrows an equal amount compared to its assets to double its bet on a collection of mortgage REITS. The leverage gives this ETN an expected yield of 24.82%.

If it sounds too good to be true, it probably is. This product just adds more debt to a collection of mREITs that are already very highly levered. With 2 times the leverage, owning the ETRACS Monthly Pay 2x Leverage Mortgage REIT ETN it is similar to owning the previously mentioned mREITs with twice the debt levels. Sure, you also get twice the yields, but you have twice the downside risk. These four mREITs are the four largest positions in the ETRACS Monthly Pay 2x Leverage Mortgage REIT ETN.

Exposure at 2 times leverage

With these weightings and a 2 times exposure, at those debt levels, small, adverse moves to Annaly or American Capital Agency, or moves to the mortgage REIT sector as a whole, can spell disaster for an investor in the ETRACS Monthly Pay 2x Leverage Mortgage REIT ETN.

It's also important to note that the ETN is meant to track 2 times the monthly return on the index. With all leveraged products, there is near certainty that the ETN will diverge significantly from the index over longer periods than it's designed for as the leverage is reset monthly and the costs of the derivatives the ETN uses to track the index eat into the ETNs returns.

For example, if over a two-month period, the mREIT index moved down 10% in the first month, then up 10% in the second month, the 2x index will finish more than 2x down from the regular index over the entire period.

While the ETN doesn't have as much tracking risk as some of the products that are meant to track the daily movements of indices, it's still a near certainty.

Foolish bottom line
Stay away from the ETRACS Monthly Pay 2x Leverage Mortgage REIT ETN.