Game Of Yields: 8% With Safety

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 |  Includes: CYS, DX, MITT
by: Dividends & Income Daily

Summary

Mortgage REITs are very popular among income investors due to their high dividend yields.

These high yields are not without risk—mREITs manage highly-levered portfolios of relatively complicated securities.

The mREIT preferred shares are excellent options for investors looking for high yield, but added safety.

It's clear that the policy responses of central bankers (let's just call them central planners) have spurred a global chase for yield. Investors have bid up dividend stocks and government debt alike, pushing yields down in the process.

As a result, mortgage real estate investment trusts (mREITs) have become increasingly popular among income investors, because yields in this industry remain high.

For instance, Annaly Capital (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC), the two largest mREITs, have common stock dividend yields of 10.6% and 11.7%, respectively. Before jumping on board, however, it's important to keep in mind that reward is meaningless without taking risk into consideration.

Beware of the Shadow…

Mortgage REITs basically invest in mortgage-backed securities [MBS], using borrowed funds (leverage) to increase income. They're considered part of the so-called shadow banking system, because they're essentially specialized banks.

You see, mREITs earn the spread between the interest income from their investments (like a bank loaning money) and their cost of borrowing. However, traditional banks have advantages - such as low-cost, reliable funding from bank deposits - that make their businesses much less risky, not to mention that leverage is a double-edged sword.

Mortgage REITs produce a lot of income due to their higher leverage ratios, yet this also makes them much more vulnerable to rising interest rates, since the value of their MBS holdings can decline and/or their cost of funding can rise. in a crisis, mREITs may have trouble obtaining short-term financing and may have to liquidate holdings at fire-sale prices.

Because of all of these inherent risks associated with mREITs, it's not surprising that they offer very high yields. Yet, as you're about to see, yield isn't everything. The chart below compares the total return of the FTSE NAREIT Mortgage REIT Index to that of the KBW Bank Index.

Despite having higher yields, the mREIT industry as a whole has underperformed its close relative - the banking industry.

This is because the mREIT industry has had more than its fair share of failed companies. These blowups have weighed on the Index, but periodic failures should be expected in an industry with such highly levered companies.

Don't give up on mREITs entirely, though. There is a way to invest in these companies and maintain a higher degree of safety at the same time; look to their preferred shares.

Protection Against an Assault

Preferred stock is senior to common stock. This basically means that the dividends paid to preferred shares have priority over the common stock dividends.

If the mREIT faces a cash shortage, it can stop paying the common stock dividend and keep paying the preferred dividend, but not vice versa.

If the mREIT files for bankruptcy and liquidates, the preferred shareholders receive any proceeds (up to a maximum of the liquidation preference) before common shareholders get paid. This is a benefit of being higher in the capital structure.

Think of the common equity as the wall around King's Landing in Game of Thrones. Those walls have to be breached before the heart of the city is harmed. As investors, we like safety. We want to be behind the castle walls when there's an attack.

Better yet, most mREIT preferreds are also cumulative, which means that if dividends are skipped, they need to be made up before the normal resumption of dividend payments. This gives us even more security.

So where should you begin looking?

Well, there are currently only a handful of cumulative preferred shares - in any industry - that yield above 8% and trade at a 5% or greater discount to their liquidation preference. The three mREIT preferreds listed below possess these qualities.

The AG Mortgage Investment 8% Series B Preferred [MITT-B], CYS Investments 7.5% Series B Preferred [CYS-B] and Dynex Capital 7.625% Series B Preferred [DX-B] offer some of the safest 8% yields around right now.

These perpetual (no maturity date) preferreds may yield less than each of their respective common equity shares, but the lower risk is certainly worth the tradeoff. Best of all, the managements at these companies aren't using excessive leverage.

In fact, the leverage ratio (debt-to-equity) at AG Mortgage Investment is one of the lowest in the industry, at 4.1x. The leverage ratios at Dynex Capital and CYS Investments are 6.1x and 6.3x, respectively. They're higher, but still reasonable by historical industry standards.

Keep in mind, these preferreds are relatively illiquid (lower trading volumes), so their shares can be extremely volatile. Because of this, it's a good idea to dollar-cost average into positions. This will also allow us to take advantage of sell-offs in this industry related to fears of rising interest rates.

As I've shown, mREITs are risky investments. These firms manage highly levered portfolios of relatively complicated securities. Stick with their preferreds that offer you a layer of protection. The three I've mentioned are excellent options for investors seeking high yields and safety. They're also nice complements to the closed-end funds yielding over 8% I talked about in February.

As always, Dividends & Income Daily is your trusted guide in the Game of Yields.

Safe (and high-yield) investing,

Alan Gula, CFA

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: Dividends & Income Daily is a team of financial researchers. This article was written by our Editor-in-Chief, Alan Gula, CFA. We did not receive compensation for this article, and we have no business relationship with any company whose stock is mentioned in this article.