Amid plunging interest rates and big drops in payouts from fixed-income securities and other income-producing investments, investors have scoured the universe of available investments for higher income. Real estate investment trusts that invest in mortgage-backed securities have been a godsend for cash-starved investors, with their double-digit percentage dividend yields going a long way toward making up for income shortfalls from other asset classes.
But even with support from the Federal Reserve for mortgage-backed securities, mortgage REIT payouts are still on the decline. The question is how long the dividend drops will persist, and whether we're closing in on a bottom for mortgage REIT dividend yields.
Watch out for falling dividends
Late last week, Anworth Mortgage Asset (NYSE:ANH) became the latest mortgage REIT to reduce its payout. Although the $0.15 per share quarterly payout still represents a better than 9% yield, the 17% reduction in the dividend marks the second straight quarterly cut and the fourth drop in five quarters for Anworth, which has seen its payout fall by more than half since its peak in mid-2009.
Anworth isn't the only mortgage REIT to face such problems. Annaly Capital (NYSE:NLY) reduced its dividend by 9% in its most recent quarter, bringing total cuts since the end of 2009 to a third of its former payout. Chimera Investment (NYSE:CIM) sustained its $0.09-per-share dividend in its most recent quarter but has made five cuts in the past two years. Hatteras Financial (NYSE:HTS) took another dime off its quarter payout in September, while Cypress Sharpridge (NYSE:CYS) chopped its dividend by a nickel.
What's going on?
The big culprit for mortgage REITs is coming from falling interest rate spreads. On one hand, low interest rates are great for mortgage REITs, because the short-term rates they pay to borrow money make obtaining capital very inexpensive. But the flip side of that argument is that when the Fed takes extraordinary measures to keep not just the short end of the yield curve down but also longer-term bond rates as well, it reduces the amount of interest income they earn on the mortgage-backed security positions they hold.
The banks that typically lend to mortgage REITs are also in a better condition to negotiate from a position of strength. As banks enjoy higher interest rate spreads, it squeezes the amount of profit left for mortgage REITs.
Finally, prepayment trends are threatening the viability of mortgage-backed securities as a long-term investment. With mortgage rates having trended ever lower, homeowners have had huge incentives to refinance their mortgages on multiple occasions, despite fairly high closing costs in some cases. Refinancing triggers prepayments on mortgage-backed bonds, leaving investors with the unappetizing question of what to do with unexpected returns of capital.
The bad news for mortgage REIT investors is that these adverse conditions could last for quite a while. The Fed has promised to keep injecting more money into the financial system as needed, which could extend worsening rate spreads indefinitely.
To see how bad things could get, though, all you have to do is look back at Annaly's dividend history. Compared to its most recent dividend of $0.50 per share, the mortgage REIT's lowest dividend in recent history was a mere $0.10 per share. It's unlikely that the market will get that bad anytime soon, but it certainly shows how much room there is for future dividend reductions if appropriate.
Before you look at mortgage REITs as a perfect place for dividend income, make sure you understand all the ins and outs of how they work. That way, you won't get blindsided if they end up cutting dividends even further from where they currently are. It may well be that dividends aren't near an eventual bottom just yet.
Fool contributor Dan Caplinger likes payouts he can count on. You can follow him on Twitter @DanCaplinger. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. 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 Fool's disclosure policy never collapses on you.