Dividend stocks are everywhere, but many just downright stink. In some cases, the business model is in serious jeopardy, or the dividend itself isn't sustainable. In others, the dividend is so low, it's not even worth the paper your dividend check is printed on. A solid dividend strikes the right balance of growth, value, and sustainability.
Today, and one day each week for the rest of the year, we're going to look at one dividend-paying company that you can put in your portfolio for the long term without too much concern. This isn't to say that these stocks don't share the same macro risks that other companies have, but they are a step above your common grade of dividend stock. Check out last week's selection.
This week, we'll turn our attention to the financial sector, and I'll show you why mortgage-REIT American Capital Agency (NASDAQ:AGNC) is a supercharged income-producing company you can trust.
The brewing storm
Mortgage REITs, or mREITs, were all the rage just a few short years ago because of their double-digit dividend yields, strong net interest margins -- the profit they gain from the difference between the interest at which they borrow, and the rate at which they lend -- and historically low lending targets as set forth by the Federal Reserve, which appeared to signal years of expected outperformance.
However, the allure of mREITs has faded almost as quickly as it built up. My initial assumption of the sector in January 2012 was that it had been given a green light for success with the Federal Reserve focused on keeping lending rate targets between 0% and 0.25% throughout 2015. That proved to be an incorrect assessment because of the ongoing effects of Operation Twist and Quantitative Easing 3, or QE3.
Operation Twist involves the Fed selling short-term U.S. Treasuries and then buying equal amounts of long-term U.S. Treasuries. The end result tightens the spread that mREITs use to turn a profit. QE3 was undertaken to stabilize the economy and a shaky housing sector, and it has involved the Fed purchasing $40 billion worth of mortgage-backed securities on a monthly basis. The negative for mREITs here is that it's taken a good chunk of MBSes out of play and left mREITs like American Capital Agency -- and Annaly Capital Management (NYSE:NLY), the nation's largest mREIT by assets held -- with far fewer profitable MBS purchase opportunities.
The final factor that hasn't helped is the gray cloud that overhung Chimera Investment (NYSE:CIM) for much of the past year and change. An accounting error, or as my Foolish colleague John Maxfield would describe it, a "competence error," at Chimera delayed the filing of its 2011 report for more than a year and ultimately reduced its reported profits in an audit going as far back as 2007 by $695.5 million, or 65.5%. This clearly didn't help the mREIT sector's public image.
The rising sun
However, it appears that the sun may once again be rising on the mREIT sector -- specifically for those that operate in agency-backed loans.
The reasoning behind my sudden optimism is inspired by comments made by top officials at the Fed earlier this week that it could begin winding down its monthly $85 billion in bond-buying programs ($45 billion in Treasuries + $40 billion in MBSes) as early as the summer if the U.S. economy continues to improve. With a bigger pool of MBSes to choose from, American Capital will be able to focus more on quality than quantity and should net a higher net interest margin.
Agency or non-agency?
What this really comes down to is a decision to purchase an mREIT that buys agency-backed loans -- ones in which the MBSes are backed by the full faith of the U.S. government -- or non-agency-backed securities -- MBSes not secured by the government.
Chimera and Invesco Mortgage Capital (NYSE:IVR) are two good examples of non-agency mREITs. The advantage of non-agency mREITs are the higher net interest spreads, but they also come with a price. That price being that the amount of leverage these REITs can utilize tends to be lower than agency-backed mREITs, and the potential for losses based on default is also very high.
American Capital Agency, Annaly Capital Management, and CYS Investments (NYSE:CYS) are three perfect examples of agency-backed mREITs. You'll give up some net interest margin potential owning these three names as opposed to Chimera or Invesco, but these agency-backed mREITs also come with the added protection of having their MBSes protected against default. The end result is that they can ultimately use leverage to a much greater, and arguably safer, degree than non-agency mREITs.
My oh my, that dividend!
But, let's face it: The most impressive aspect of American Capital Agency -- and why investors can't get enough of the company -- is its dividend.
Unlike most companies highlighted in this weekly series, American Capital isn't going to give its shareholders consistent increases. All dividend payouts are based on the previous quarters' operating conditions. Even without that certainty, there's been little downside to American Capital's dividend over the previous four years.
With the prospect that MBS' will soon become more abundant as the Fed lessens its own buying, I foresee American Capital's dividend remaining stable, or perhaps even heading higher than its current $5 per year. The current yield is a whopping 15.3%.
We're about to enter the true sweet spot for mREIT growth; that point in between where the Fed begins winding down its bond-buying, and when it actually boosts its target lending rate -- which isn't expected to occur prior to 2016. That's going to give mREITs about 8 to 10 quarters to absolutely run wild! For American Capital, that could amount to cumulative distribution of $10 to $13 per share for investors.Unless the Fed drastically changes its view of the economy, American Capital appears to be a safe bet for the income seeking investor.