Unpopular Opinion: Do Not Buy and Hold Common Shares
In spite of offering double digit dividend yields, mortgage REIT common shares are an ineffective way of generating total return. The long-term performance of the asset class as a whole has proven to be a wealth destroyer and macroeconomic conditions do not support a bullish outlook. I do think, however, that their baby bonds and preferred shares can be a very worthwhile investment for income investors because they typically offer 6-8% annual yields with much less volatility. Furthermore, fixed income products that have a maturity date are more likely to achieve an acceptable total return if you simply hold to maturity.
Mortgage REIT Drivers In A Nutshell
Using the iShares Mortgage REIT ETF (REM) as a proxy for Mortgage REIT common shares, you can see that the sector is highly correlated to interest rates. That makes sense given that a common strategy is to borrow at short-term rates and use the proceeds to invest in a portfolio of mortgage (both Agency and Non-agency) assets.
Considering that interest rates have fallen in earnest over the past several decades, sector profitability has been under pressure. Further compounding the issue is that funding costs have increased while long-term rates have fallen. Even with their hedging strategies, margins have been squeezed by macroeconomic conditions and monetary policy. Does that make you confident that these firms can support such high dividend yields?
To illustrate this point, take a look at REM's distributions since 2013:
(Source: Original Image - Data From Yahoo Finance)
Looking at historical distributions, you can distinctly see the "L" shape of distribution cuts. The ETF offers broad exposure to the sector but is very top-heavy to some household names. The top 5 holdings make up 50% of total exposure.
(Source: Original Image - Data From REM Factsheet)
So Where Does That Leave Us?
To ensure an acceptable total return, consider fixed income products such corporate bonds, baby bonds, and preferred shares. Currently there are some attractive options. NLY perpetual preferred shares are trading close to par value and are near their call dates. According to their financial statements, the firm boasts a wide margin of safety for their preferred shares with over 10X preferred dividend coverage. MFA has a rather long duration bond set to mature in 2042 but they have also maintained a reasonable margin of interest safety to support that debt. It should be noted, however, that the latter firm does utilize a rather aggressive strategy with a portfolio of alternative mortgage assets.
Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.