Yield, yield, yield.
If there is one topic that interests Income & Prosperity readers more than any, it’s yield and where to find it. Readers want to know where to capture safe high-yield income.
Now for the harsh reality: there is no such place. There is always risk involved when reaching out for yield. But this isn’t to say that certain yield isn’t worth the risk. For instance, mortgage REITs offer double-digit yield. Better yet, the benefits of that yield appear to outweigh the risk.
If you are unfamiliar with mortgage REITs, you need to understand that they are unlike conventional REITs. Most conventional REITs buy physical properties and make money from leasing them. Mortgage REITs, in contrast, are really financial companies. Instead of investing in physical properties, they invest in mortgages and mortgage-backed securities.
I haven’t always been on board with mortgage REITs. For most of the past four years or so, I’ve viewed them as persona non grata. Most have significantly reduced their payouts over that time. The largest and most popular mortgage REIT, Annaly Capital Management (NYSE: NLY), has reduced its dividend by more than half. Its share price has followed lock-step.
Spread compression has been the issue. Mortgage REITs borrow short-term and then use the proceeds to invest in long-term mortgage-backed securities. After the financial crisis, short-term rates were reduced to near zero, while long-term mortgage rates remained elevated. Spreads were juicy, as were dividend payouts.
But then long-term rates drifted lower. The rate on the 30-year fixed-rate mortgage dropped to 3.5% from over 5%. Spreads compressed, and so did dividend payouts.
Mortgage REITs are still persona non grata to many investors. The fear is that spreads will compress further when the Federal Reserve begins to raise short-term rates.
I don’t see it quite that way. First, I’m unconvinced that the Fed will begin to raise interest rates. There are still enough pockets of economic sluggishness to forestall an increase.
In addition, inflation remains muted, so no need to raise rates on that account. The strength of the U.S. dollar on the world currency markets is also a mitigating factor. A rate increase would further strengthen the dollar.
But if I’m wrong, I don’t see much spread compression anyway. If short-term rates rise, they’ll likely rise in small increments. Spreads won’t compress much, or at all. What’s more, it’s possible that long-term rates could be pressured to rise as well, thus maintaining spreads.
In short, I like the risk-reward paradigm of mortgage REITs. The aforementioned Annaly Capital has piqued my interest with its 11.6% yield. But I like another mortgage REIT even more – PennyMac Mortgage Investment Trust (NYSE: PMT), which yields 11.4%.
Like Annaly, PennyMac invests in residential mortgage loans and other mortgage-backed assets, but it does so with a twist. PennyMac focuses on investing in distressed mortgage loans available for acquisition from financial institutions. In addition, it has a correspondent lending arm, which means it originates and sell mortgages to other lenders. PennyMac is more than a play on yield-curve spread.
When most mortgage REITs were reducing dividends, PennyMac was increasing its dividend. Since 2010, the quarterly dividend has increased to $0.61 a share from $0.35. The latest increase occurred two quarters ago. Just as important, the dividend has never been reduced.
Leverage also favors PennyMac. All mortgage REITs use leverage, but PennyMac uses significantly less. Most mortgage REITs are leveraged 5-to-1. PennyMac is leveraged 2-to-1. Less leverage, less financial risk.
Risk is further mitigated through operational diversification. PennyMac continues to build out its lending and services operations business, which makes it less vulnerable to interest rate movements.
So, if you are an income investors with a few pennies that are in search of high yield, PennyMac just might be the place to bank them.
Dividends for Every Month of the Year
If you’re looking for just one dividend stock to round out your income stream, consider a little-known company that pays out dividends 12 months of the year.
Click here to see the full details of this company in my Dividend Calendar…