High Risk - High Reward: Maybe, Maybe Not

Includes: AGNC, EFC, MTGE
by: Henry Nyce

Everyone who invests in the stock and bond market should know that one is putting his or her capital (hard earned savings) at risk. At the age of 18 I made my first foray into the stock market. It was a small oil drilling company touted by my father's broker. Several months after purchasing 500 shares, the Wall Street Journal reported that the company was being sued by another oil company for slant well drilling. The stock immediately swooned and I lost 95% of my hard earned savings invested in this stock.

This was the first important lesson I learned about investing; it does not always offer you the rewards you expected. I discovered that I could lose all of my investment in a particular stock in a day. This lesson profoundly affected my investment philosophy. Since almost any stock or bond I select may go to zip in a day, my portfolio is filled with many different stocks and bonds. No one company ever gets more than 2% of my portfolio.

A second lesson came from my investment in MMAB. I purposely keep 1700 shares of Municipal Mortgage and Equity (MMAB) in my IRA account. Each day as I view my account this investment shows a loss of $17,698. This loss is a reminder NOT to load up on a stock as its price goes down. This company was paying a very high dividend and I was sure it was a safe company. After all, it was insuring bonds of agencies that had the ability to tax. But I was wrong and some municipalities went belly up and MMAB went south. It illustrates the truth to the statement, "No such thing as a sure thing."

This expensive loss of capital taught me 2 things;

  1. High dividends entail greater risk
  2. Buying more of a stock as it goes down can put your hard earned savings at risk. Instead of cashing in, I was cashed out.

After these lessons, one would think that my taste for risk should have been reduced and that I would put my hard earned savings in the bank where the government guarantees it. However the 2 stories above only cover half the story. There are times when I put my money at high risk and gained high rewards. Soon after the Carter administration was ended, I began to purchase corporate bonds that were selling at half the stated value of the bond. So a 5% $1000 bond was selling for $500 offering 10% instead of the stated return. I bought a large assortment of these corporate bonds.

Out of 10 different corporate bonds I purchased, one company went bankrupt and all of the money invested in that bond was lost. On the other hand, I more than doubled my money on the 9 other bonds. As interest rates began to go down these bonds rose to par or sometimes above while collecting my interest payments. Here is a case where I collected high rewards for high risk investing. This experience also demonstrated the value of diversification. I lost my capital on 1 bond, but easily recovered the loss with the other 9 investments.

The purpose of these stories is to alert income investors that high dividends or high interest rates often carry high risks. The greater the return, the greater the opportunity to lose all your money in that particular venture.

Let's look at some recent examples of issues being touted on Seeking Alpha that demonstrate this extremely high risk.

There are many mortgage REITs that are presently being touted in the dividends and income section of Seeking Alpha. (E.G. AGNC, EFC, MTGE and others.) Some of them are offering double digit dividends in the 10 to 15% range. When 30 year mortgages are only collecting 4-6%, how can a mortgage REIT offer a dividend of 2 to 3 times that amount in return for handling them? It does so by taking on risk. They borrow short tem money at low rates, 1-2%, and capture the difference between the short rates and the long rates. They leverage their capital structure 3 - 8 times.

When short term rates rise, which they undoubtedly will, the profitability of these companies will be in danger. They will be carrying long term mortgages that are only collecting 4 -6%. On the other hand they must refinance the levered portion of their portfolios with these higher short term rates. If short term rates were to rise to 5-6%, these companies would begin to lose money. When that occurs, not only will the dividends go down, but the price of the REIT will descend also. Investors in these REITs will lose capital big time in this scenario.

The authors touting these issues rarely warn you of the interest rate danger involved in these REITs. They may assume you understand the danger or they may not be aware of the danger themselves. Therefore you must do your homework and understand the risks involved with these high dividends. If you decide to invest in these entities, make sure that you are only putting a portion of your holdings in these REITs. Furthermore, be ready to move out of them at the first sign of rising interest rates.

Another example recently covered in Seeking Alpha is Great Northern. GNI was offered as a dividend stock in an article entitled 6 Inexpensive Stocks With Recent Dividend Hikes. The author informs you that it has a great dividend, a low price/earnings ratio and ample cash flow to continue the dividend. Upon researching the stock I found the paragraph below:

Great Northern Iron Ore Properties (Trust or GNIOP) will cease to be a going concern and all shares will be cancelled, on April 6, 2015. According to the terms of the Great Northern Iron Ore Properties Trust Agreement, created on December 7, 1906, the Trust terminates 20 years from April 6, 1995, that being April 6, 2015. On April 6, 2015, GNIOP, by its terms, will dissolve, and all of its trusts will be terminated and shares will be cancelled. At the end of the Trust on April 6, 2015, the certificates of beneficial interest (shares) in the Trust will cease to trade on the New York Stock Exchange. (taken from TD Ameritrade's research page on the issue)

GNI will be nearly worthless in 3 years. This was not mentioned in the article. However one commentator writing below the article pointed this out. If one only read the article and purchased the stock for its wonderful dividend, the future capital loss would overwhelm any returns from the dividend if one held the stock for any length of time.

In conclusion here is a summary of what I learned from my experience with high risk - high reward investing:

  1. Make a concerted effort to understand the risks associated with high yields or high dividends before you buy.
  2. When you understand the risks, set up a method to protect yourself from loss of capital if you decide to cash in on these high returns.
  3. No matter how good your homework and research, there are no sure things. There are crooks, thieves and upheavals that can destroy the best of companies and with it your investment.
  4. Diversify, diversify and diversify. Spread your investments out over different companies, industries and even countries.
  5. Finally, when one of your issues is declining, do not rush in to buy more. There generally is a good reason for the decline. Often the best thing to do with a declining issue is to sell rather than to buy some more.

Disclosure: I am long MMAB.PK, EFC.

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