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Thursday, January 10, 2013 - 08:30
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Thursday, January 10, 2013 - 08:30

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Thursday, January 10, 2013 - 8:30am

If a rich yield is your goal, then few investments can compete with mortgage real estate investment trusts (REITs).

These stocks currently pay exceptional 9-19% dividend yields. In a world where U.S. Treasuries yield just 2%, these REITs truly offer extraordinary performance. Mortgage REITs can afford to pay outsized dividends because they must distribute the majority of their income to investors and utilize leverage -- borrowing money at low rates and investing in high-yielding mortgage securities -- to amplify shareholder returns.

Despite generous dividends, prices for mortgage REITs took a beating in the second half of 2012, after the Federal Reserve launched a $40-billion monthly purchasing program for agency-backed mortgage securities. As a result, demand for mortgage securities rose, yields fell and the spreads mortgage REITs earn from their investments declined. Major players such as CYS Investments (NYSE: CYS), American Capital Agency (NYSE: AGNC) and Annaly Capital (NYSE: NLY) experienced price declines of 20% or more.

The good news is that mortgage REITs may be poised for a comeback this year, as higher taxes on dividends and capital gains for upper-income earners make these investments more appealing.

[Because REITs pay no corporate taxes, they aren't qualified for the lower dividend tax rate. In addition, a big portion of REIT dividends typically consist of return of capital. This reduces the investor's taxable income in the year the dividend is received, lowers the cost basis of the investment and defers taxes until the investment is sold.]

Here is a look at the five highest-yielding mortgage REITs:

1. Two Harbors
Yield: 18.8%
Two Harbors (NYSE: TWO) mainly invests in residential mortgage-backed securities (RMBS) guaranteed by government agencies (such as Fannie Mae). These represent 83% of the REIT's $15-billion portfolio. Two Harbors also owns a 47% stake in Silver Bay Realty (NYSE: SBY), a new residential REIT.

During the third quarter of 2012, earnings per share declined 22% to 31 cents from 40 cents a year earlier, due to lower yields on recently-purchased mortgage securities. The REIT's third quarter dividend of 36 cents a share wasn't fully covered by earnings. Two Harbors declared a 55-cent dividend for the fourth quarter, but may struggle to maintain current payout if earnings from new investments continue to slide. The company has $834 million of cash to cover the dividend.

2. Western Asset Mortgage Capital Corp.
Yield: 16.9%
Western Asset Mortgage Capital Corp. (NYSE: WMC) is new agency mortgage REIT is managed by Western Asset Management Co., which is owned by Legg Mason (NYSE: LM). During the September quarter, its first quarter as apublic company, Western Asset generated solid earnings of $2.72 per share, increased book value 10% to $21.76 a share and paid an 85-cent dividend. The company's $4.6 billion portfolio of mortgage securities consists mainly of 30-year fixed-rate agency-guaranteed RMBS.

Because it is new, this REIT is experiencing lower prepayment rates than its competitors. This helps Western Asset maintain a favor spread between yields on investments and borrowing costs. Management signaled confidence by raising the dividend 5% in the December quarter to 90 cents a share, while distributing an additional dividend of 22 cents a share to investors.

3. American Capital Agency Corp.
Yield: 16.1%
American Capital Agency Corp. (Nasdaq: AGNC) has a $90-billion investment portfolio and ranks as the country's second-largest mortgage REIT. You may already be familiar with this stock as it's been featured in Carla Pasternak's High Yield Investing.

Investments consist mainly of agency-guaranteed RMBS. The REIT is also highly leveraged, with debt of $80.3 billion totaling more than seven times equity.

While the REIT's earnings more than doubled in the third quarter to $3.98 per share from one year ago, most of the increase was non-cash unrealized gains on investments. Year-over-year Taxable earnings declined 27% to $1.36 a share. American Capital has maintained its quarterly dividend at $1.25 all year after cutting payout in June 2011 from $1.40.

4. New York Mortgage Trust
Yield: 16.3%
New York Mortgage Trust (Nasdaq: NYMT) invests in agency-guaranteed and non-agency RBMS, and owns a $990-million investment portfolio. New York Mortgage changed managers and used stock offering to grow its portfolio in 2012. The result has been a significantly-improved financial performance.

Third-quarter earnings jumped to 30 cents a share from no earnings a year earlier, which were more than sufficient to cover the 27-cent dividend. The REIT has also declared a fourth-quarter dividend of 27 cents a share.

5. Resource Capital Corp.
Yield: 13.4%
Unlike the residential mortgage REITs mentioned above, Resource Capital Corp. (NYSE: RSO) specializes in commercial real estate. Roughly 87% of the $2.3 billion commercial real estate loan portfolio consists of senior debt (the safest kind) and most of the REIT's mortgage debt is adjustable rate, which provides some protection against rising interest rates. This REIT is externally managed by Resource America Inc. (Nasdaq: REXI).

Resource Capital's September quarter earnings were 20 cents a share, the same as a year earlier. The REIT pays a 20-cent quarterly dividend. The company has made good progress recently cleaning up its balance sheet, so leverage has declined from a high of 10 times a few years ago to 2.9 times today.

Risks to Consider: Dividend cuts are common for mortgage REITs, so these investments must be monitored carefully. The biggest risks come from increases in interest rates and prepayment. Interest rates are unlikely to rise significantly this year, but investors should be cautious if prepayments rates accelerate since this affects the REIT's earnings and ability to pay dividends.

Action to Take --> My top picks from this group are Western Asset and New York Mortgage. Both are easily covering their dividends from earnings and steadily improving their book value and financial performance. Of the two REITs, Western Asset is likely the safer choice due to its larger portfolio and skillful management of prepayment risk. This mortgage REIT is also attractively priced at a 4% discount to book value.

P.S. -- StreetAuthority's High Yield Investing is dedicated to bringing investors the highest-paying and most stable stocks, bonds and funds on the market. Click here to learn how to profit from some of our latest income investing picks.

Lisa Springer does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of AGNC in one or more of its “real money” portfolios.