This has been an interesting year in the stock market.
As the market has been lifted to all-time highs by an accommodative monetary policy and an economy starting to fire on all cylinders, long-term investors have profited handsomely during the first half of the year. A pullback in August led the Dow Jones Industrial Average to drop nearly 1,000 points before stabilizing in the 14,800 range. Despite this setback, stocks are still showing signs of strength that should last for the rest of the year.
But the fuel powering the stock market has its drawbacks: Low interest rates and accommodative policy have sent yields to ultra-low levels while boosting stocks. In fact, income investors have become so frustrated by the lack of yield that this year's investing theme can be summed up in four words: the search for yield.
I learned from my colleague Nathan Slaughter's Dividend Opportunities advisory that in 1984, one-year bank CDs paid an astounding 10.4%. Yields of 9% were commonplace in the stock market after the 2008 market crash. Today, the stocks in the S&P 500 index pay an average yield of just 2.02%. Even the traditional high-yield sectors, like international utilities, are only yielding about 4%.
Further cementing the dire yield situation, Nathan ran a screen on all 12,592 U.S.-traded stocks and ADRs (American depositary receipts) -- and found that only 170 stocks of the 12,592 pay dividends higher than 9%.
But high-yielding stocks do exist in this low-yield environment. However, before I talk about one of my favorites, it's critical to understand that with high yield comes high risk. This stock is not suited for risk-shunning conservative investors but rather for those investors who understand the risk and are willing to accept it -- in return for mind-blowing yields.
My favorite stock in the ultra-high-yielding space is the agency mortgage REIT, American Capital Agency (AGNC). This stock yields over 18%, which is amazing provided the low-yield environment.
A REIT, or real estate investment trust, is required by law to distribute 90% of its profits back to shareholders, hence the high yields. Mortgage REITs invest in real estate mortgages, and an agency REIT is one that only invests in government-backed mortgages. This lowers the credit risk due to the government insured nature of the mortgages.
Mortgage REITs typically leverage between six and 10 times their actual funding level. Money is made on the spread between the mortgage interest rate and the short-term interest rate. The wider this spread, the more money a mortgage REIT can make thus pass along to shareholders. This spread is the lifeblood of mortgage REITs and is where the risks and profits lie.
Rising interest rates will negatively affect many mortgage REITs. However, those that invest in 15-year mortgages rather than the standard 30-year have a stronger chance of maintaining the high yield. American Capital Agency has transferred 42% of its portfolio to these "safer" shorter-term mortgages. This flexibility shows management's willingness to change with the environment to maintain the high yields. It is my prime reason for choosing this mortgage REIT as an investment.
In addition, Gary Kain, American Capital's president and chief investment officer, gave shareholders further confidence:
"The second quarter was characterized by extreme volatility in both interest rates and mortgage spreads. In response, we remained highly disciplined with respect to our risk management activities. We reduced the size of our asset portfolio, adjusted our asset composition to be more consistent with a higher rate environment, and materially increased the duration of our hedges. As a result of these actions and evolving market conditions, our exposure to higher rates is lower than it has been in years, and our 'pay-up' risk is now minimal."
Looking at the nitty-gritty of the company, its investment portfolio totals nearly $92 billion of agency (government-backed) securities, including more than $14 billion of net TBA (to be announced) fair value mortgage positions. The company pays out $4.20 per share in annual dividends. It boasts a price to book ratio of 0.85 and appears well prepared to continue its high-performing dividend yields.
Risks to Consider: Interest rate spread risk is the primary danger to mortgage REITs. In addition, there is a pending risk of Fannie Mae and Freddie Mac being shuttered. This means that there would be a shift in the security of the underlying mortgages. How this will affect agency mortgage REITs is not clear. The Federal Reserve's eventual exit from quantitative easing may also pose a danger to mortgage REITs. Remember, there is a high risk involved with obtaining these high yields.
Action to Take --> I like American Capital Agency right now: Its price is off the highs, and the metrics currently paint a compelling picture. Other high-yielding mortgage REITs includes Annaly Capital Management (NLY). Those who seek diversification across the high-yielding mortgage REIT space can invest in a mortgage REIT exchange-traded fund like the Market Vectors Mortgage REIT Income Fund (MORT). This ETF consists of 14 of the highest yielding mortgage ETFs on the market; the top two holdings, as you might guess, are American Capital Agency and Annaly Capital.
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