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I have written extensively about the agency mREIT sector. The major attraction that the sector offers are extremely high dividend yields. Investors seeking income are drawn to many of the stocks within this sector, and might even allocate too high of a percentage of their investment dollars within it. The entire sector is faced with a steady stream of headwinds that are constantly changing. Each of the companies' fortunes can change with one government program or with one Federal Reserve announcement.

As far as I am concerned, there are only two companies that should be considered "best buys" for a dividend seeking investor: Annaly Capital (NYSE:NLY) and American Capital (NASDAQ:AGNC).

Performance Is Everything

Both of these companies have consistently performed quite well in the most confusing era of interest rates that I have ever seen. As most of you know, I favor Annaly, but in the last few years AGNC has outperformed NLY. By using a higher degree of leverage, AGNC has been able to produce greater returns and higher dividends. The company has had a somewhat steadier dividend rate, and as of now it has not had to reduce dividends as much, or as often, as NLY has.

NLY has taken a more conservative approach to the market sector and has judiciously navigated through more interest rate environments than AGNC. The company has been public since 1997, nearly a decade longer than AGNC, and has the vast experience of making money during virtually all different economic and interest rate environments.

From the NLY company website:

Click to enlarge images.

A picture is worth a thousand words, and this chart basically says it all. Through good times and bad, NLY has total returns that literally blow the market metrics (including the S&P 500) out of the water. A total return of roughly 600% is nothing short of astounding. Clearly, if an investor held shares in this one stock, the value of his or her portfolio would be stunning to say the least.

This chart is from the AGNC website:

Stock chart for: AGNC

As you can see, the consistency of the share price as well as the dividends paid has been remarkably steady. AGNC has only been around since 2008, but its management team has shown a brilliant course of action that has returned shareholder value in the current interest rate environment. Even though AGNC has less of a track record than NLY, there is no denying the fact that it has performed much better than NLY over the last two to three years.

The Dividend Data

Investors who own shares of these stocks are not looking for dramatic capital appreciation. The single reason why investors own these stocks are for the dividends. Any rise in the share price is a bonus, but based on both of these companies business models, a rising share price is the one way that each can generate more money -- additional stock offerings. By issuing more stock when the price is up, each company can raise more capital to redeploy into the mortgage-backed securities market. Putting more money to work will create more profits and dividends can continue to be paid.

When the share price falls too far, each company can decide to buy shares back at a discount, which has the affect of placing a "floor" on the share price. Since these stocks typically trade very close to book value or below, it is one of the key strategies that enable the shares to have the consistency that they have shown. Since the IRS mandate that in order to maintain a REIT status they have to pay at least 90% of earnings back to shareholders as dividends, we have a dividend chart that looks like this:

NLY Dividend Chart

NLY Dividend data by YCharts

Increases, decreases and regularity. Both companies have had to adjust the dividends paid, but surprisingly not too much given the interest rate environment. Neither of these companies will ever fall into the dividend winner category, but they are completely entrenched in the high-yield world of dividend opportunity stocks.

A dividend seeking investor needs only to see the above chart to know why he or she might own shares of these companies.

NLY Yield: 13.40%, Dividend: $0.45/share

AGNC Yield: 15.40%, Dividend: $1.25/share

Now, the share price:

NLY Chart

NLY data by YCharts

AGNC has outperformed NLY as far as capital appreciation as you can see. As I stated before, American has used more leverage (basically going further out on the yield curve) to spike earnings and dividends in this zero interest rate environment. Annaly has used less leverage and stayed more conservative, and while it has remained steady, more or less, I believe the company miscalculated the zero interest rate policy (ZIRP) environment by being too conservative.

That has been reflected in more dividend cuts by NLY and a flat share price. Over the longer term, I also believe that when the interest rate environment changes NLY will be in a better position to continue to maintain an even keel. That equation is the unknown entity for AGNC right now.

The Federal Reserve Is Calling the Shots

I believe both of these stocks fall into the risk-investment category. Neither company produces a product to sell, a toy to play with, or clothing to wear. Each of them is in the pure money business. That also happens to be the business of the Federal Reserve. Right now, the Fed has a plethora of "programs" in place that basically dictate how this money game is played. When an entity is in a business that has a government agency making the rules, I will always consider them higher risks. Having higher risks is not all bad, though. Investors are rewarded with extremely high returns to take those risks. The problem starts to appear when investors plunk down too much into these stocks.

If investors have more than a 3%-5% allocation in each of these (or a total of 10% maximum), they are asking for trouble. If the Fed decides over the weekend -- or overnight, or during the day -- to change the rules, these stocks will get clobbered. Not only will the share price get whacked, but the dividends will be slashed, and each of these companies will have a rough go of it until they can unwind their own "inventory" (money instruments). It is sort of like the bond bubble bursting, if it ever does. Investors in bonds have seen extraordinary growth during the flight to safety, but when that game changes too rapidly, the value of their holdings will drop. Bond holders can keep their bonds to maturity, however, and not suffer the capital loss, while companies like NLY and AGNC will not have it so easy.

The basic risks that these companies face are as follows:

  • Pre-payment (foreclosures, short sales, etc.) of existing mortgages will reduce revenue and profits.
  • Re-financing of existing mortgages will reduce revenue and profits.
  • If the Fed ends ZIRP, then the short end of the yield curve will rise and the spread between the longer end of the yield curve will narrow. That will cause these companies to "work" in a much tighter spread, which will impact profits and dividends.
  • The Fed can ramp up its monthly MBS and longer-term Treasury purchases from the current $85 billion each month. This could cause the longer end of the yield curve to drop, which will also cause the spread to compress. This, in turn, will impact both companies ability to maintain profits and dividends could be cut yet again.
  • The Fed could let short-term rates rise too quickly due to inflation fears. If short-term rates rise too quickly, there is the potential of the yield curve to invert. That means that short-term rates will become higher than long-term rates. This creates havoc with the mREIT business because normally they "buy (or borrow) low" (interest rates) and "sell (or lend) high." An inverted yield curve basically will put a halt to business, as neither NLY nor AGNC want to "buy high" and "sell low." This will most definitely impact everything from share price to dividends, to revenues, and to profits of these firms. Even the long-term viability of the companies themselves will be in danger.
  • Finally, a rapid rise in inflation and all interest rates will place pressure on both of the companies to turn over their "inventory." Since only the Fed has access to the printing presses, revenues and profits will take a huge hit as will shareholders.

Taking all of the above into consideration, right now the environment is quite favorable for both of these companies. By virtue of the Fed having the policies they have in place right now, it has created a more stable interest rate environment. This has enabled both of these companies to navigate and adjust to the rules that have been set by the Fed.

US 30 Year Mortgage Rate Chart

US 30 Year Mortgage Rate data by YCharts

Both companies have done a wonderful job thus far, even though there have been some precarious times (I actually sold both of these stocks when it looked too risky). Both of these stocks require regular monitoring of performance. Not to mention having to keep an eye on the Federal Reserve monetary policies, as well as the Federal government activities.

As a dividend seeking investor, I myself will not allocate more than 2%-4% in any of these stocks for all of the reasons noted above.

The Bottom Line

There are plenty of great companies in this sector, but as I stated, NLY and AGNC are best of breed and the biggest of them all. Both companies have a proven track record of solid performance and shareholder value. I believe owning either one -- or even both -- of these stocks could have a positive impact on any dividend income producing portfolio.

Disclaimer: Please keep in mind that these are my own opinions and not a recommendation to either buy or sell any securities. You should do your own research and due diligence prior to making any investment decisions.

Source: The 2 Best mREITs To Buy Right Now