The Market's Hottest Dividend Sector Is Still the Place to Be

Shares of mortgage REITs such as Annaly Capital (NYS: NLY) , Chimera Investment (NYS: CIM) , and Armour Residential (NYS: ARR) have come under pressure in recent weeks, as the economic situation continues to worsen. But does the slide in shares mean there's an even better opportunity for investors to get high yields?

A lot of news and speculation about mortgage REITs has hit the wires recently. In August, Federal Reserve Chairman Ben Bernanke signaled that he would keep interest rates low until 2013, a welcome move for American Capital Agency (NAS: AGNC) , Invesco Mortgage (NYS: IVR) , CYS Investments (NYS: CYS) , and other mortgage REITs. The signaling provided some transparency into the Fed's actions for the future.

But three other concerns have weighed on shares: declining interest rates, a change in SEC regulation, and Operation Twist.

Declining interest rates could hurt the mortgage REITs. A flattening yield curve reduces the interest-rate spread on which the companies make money. As these companies have to reinvest the proceeds of higher-yielding securities into lower yields, it could push down the spread they can realize, ultimately hurting dividends. But to offset the decline, mortgage REITs could take on modestly more leverage to maintain those eye-bulging yields. And, of course, the companies are still borrowing at near-zero rates, a fact that won't change until at least 2013, if we believe the Fed.

Speculation has been rife that the SEC might decide to limit how mortgage REITs function. Per The Wall Street Journal: "The U.S. regulator sought comment on whether mortgage REITs should lose their tax exemption or their ability to use leverage. The plan seems to be to force them to choose one of two options: become a regular corporation -- and get taxed like one -- but keep the leverage or lose the leverage and keep the tax exemption."

But at least one investment bank has come out to say that any change would probably not materially alter the environment for mortgage REITs. 

Also of concern is the so-called Operation Twist, in which the Fed swaps longer-dated bonds for short-term paper to reduce long rates, narrowing the spread. Such a move hurts mortgage REITs since they make more money with a larger spread. But the Fed has proposed only a modest investment in longer-term notes, one that is estimated to move down 10-year rates by perhaps 13 basis points, according to Jim Hamilton, a professor of economics at the University of California at San Diego. With short-term rates near zero, that would do little to affect profitability at the mortgage REITs.

Over the last quarter, mortgage REITs with longer-dated agency-backed investments, such as Annaly, CYS, and Armour have outperformed the S&P as well as mortgage REITs focused on shorter-dated agency investments, including Anworth Mortgage (NYS: ANH) and Hatteras Financial.

Foolish bottom line
Although there's a fair amount of speculation about the future for mortgage REITs, the case for the market's hottest dividend payers still looks decent. So I think the money will keep flowing to these dividend machines.

At the time this article was published Jim Royal, Ph.D., owns shares in Annaly. The Motley Fool owns shares of Annaly Capital Management and Chimera Investment. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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kevinjones199

Mortgage Rates have hit an all time low! For many, these rates will be the lowest we see in our lifetime. Rates change several times throughout the day, so to get an accurate quote search online for "123 Refi" learn about mortgage refi before you do refi on your home.

September 30 2011 at 3:08 AM Report abuse rate up rate down Reply