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Freund's Favorites- Two High-Yielding Mortgage REITs

We’re going to be taking a look at some of our highest-yielding stocks and assess the sustainability of their dividend payouts, suggests John Freund, contributing editor to Todd Shaver's BullMarket.

Just how dependable are these double-digit yields after all? Short answer: They’re as solid as it gets. Otherwise we wouldn’t recommend them. But let’s dig into the numbers and lay out exactly why we’re so confident.

What better place to start than with the highest-yielding name in our REIT universe: New Residential (NRZ) — yielding 11.8%. New Residential pioneered a whole industry by purchasing the right to service mortgages from banks that were offloading those rights when post-2008 regulations prohibited them from holding too many mortgages on their books.

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While that strategy has been extremely successful for the company, they have recently been diversifying its operations, dedicating $2 billion to Residential Securities and Call Rights, which hedge against the core business line. That’s a solid long-term strategy and places the company on surer footing in case of a broader housing market downturn.

When it comes to assessing the risk around a dividend, many simply assume that a larger payout is more speculative in nature. While that is usually the case, it doesn’t offer a complete picture.

After all, the underlying health of the company and management’s historical dividend coverage (or lack thereof) are both key indicators of how reliable that payout is going to be for the future.  

Fortunately, New Residential passes our tests on both fronts. The company has covered its dividend out of current cash flow in each of the last 12 quarters, and has even raised its dividend many times in that period.

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In 4Q18, the company earned $0.58 per share and paid out $0.50, so there is ample coverage here on core earnings alone. As long as the business continues at this level, the yield looks secure.

Over that 12-quarter span, New Residential has averaged an 82% core earnings payout ratio, meaning on average, just 82% of core earnings went to cover the dividend. That’s an astounding figure for a company with a double-digit yield.

There’s no sign of a cash crunch here and hasn’t been for the last three years. New Residential could even raise its payout yet again and we’d still feel safe given management’s sterling coverage history. 

When it comes to overall health, it’s safe to say that New Residential is as robust as a thoroughbred. Book value (a measure of what a company’s underlying assets are worth) has increased 60% over the last five years.

This includes a 6% bump last year that would have been much higher if not for volatility in the final quarter taking the final number down from its mid-year peak. The company ended 2018 with a $16.25 book value, up from just $10.00 when it was founded in 2013.

Annaly Capital Management (NLY) — yielding 11.7% — is the largest mortgage REIT in the world, investing in mortgage-backed securities via a somewhat complex process known as repurchase agreements.

For our purposes, these arrangements let Annaly engage in debt financing arbitrage, and they make money by selling and repurchasing debt over short periods of time in order to take advantage of small pricing discrepancies.

It takes scale to pull off an arbitrage program, which is where Annaly shines. Repurchases are a great business model when the economy is humming along and interest rates are low, then increases in risk as interest rates rise. Fortunately, the climate of rising interest rates has ended for the time being, with the Fed declaring that the tightening cycle has ended.

Suffice it to say that Annaly’s business model has weathered all obstacles over the years of high and low interest rates, bull and bear equity markets. And the environment looks even stronger in the near future.

The company has kept its dividend stable or increased it every year for the last five years. Meanwhile, leverage has remained steady and management continues to produce strong book value per share (above $10), meaning the underlying health of the company is solid.

We can rest comfortably knowing that Annaly raised its dividend even during the great 2008-9 recession, which is a heartening story in itself. As the economy cratered, management paid off mortgages that the government insured through Fannie Mae, Freddie Mac and Ginny Mae.

When the homeowners themselves defaulted, the company obtained the underlying loans and received payment from the agencies, covering the losses.

Granted, the stock is only up 4% on the year, but remember we’re not in Annaly for price appreciation. We’re in it to bank that beautiful 11.7% yield, and given the fundamentals and track record, we’re confident there aren’t any cutbacks in the near future.

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