Warning: Stay Away From These High-Yield Stocks
As an income investor, the dividend yields are tempting.
I’ve found yields of 14.3%… 15.1%… and even 19.6%. Annual yields that high almost sound too good to be true, but the securities offering them are a proven investment. The businesses behind these dividends have been solid for years. And their share prices have stayed in a relatively narrow range, too.
In fact, these high-yield securities were the darlings of the market during the real estate boom. Investors couldn’t get enough of these lucrative income plays.
They may have come under pressure during the real estate bust, but they quickly regained their popularity once the economy started to recover.
I’m talking about the popular mortgage real estate investment trusts (M-REITs). This special breed of REITs borrows at low short-term interest rates and invests in pools of mortgages backed by Fannie Mae and Freddie Mac (which are in turn backed by Uncle Sam) at higher long-term rates.
But even though they offer yields well into the double digits, I’m still not buying them.
Let me explain…
Last year, my mortgage servicer, Wells Fargo (NYSE: WFC), started calling me. I wasn’t behind on my mortgage payments; quite the contrary — I had never been late with a mortgage payment in 17 years.
It wanted me to refinance my existing mortgage. Once I crawled through the offer, I realized it was a good deal for me.
Wells wasn’t going to charge me an appraisal fee — it already had done the homework to show I had more than 50% equity in my home. And there were no other fees, hidden or otherwise, to refinance my existing debt.
At a lower interest rate for a 15-year mortgage, I could save a lot of money off my monthly bill. But that wasn’t my plan. I realized that I could pay my current amount, prepaying additional principal on the loan, and shave nearly six years off the life of my mortgage.
I would save tens of thousands of dollars in interest payments and pay off my mortgage in roughly nine years. It seemed like a no-brainer.
But something about the offer bothered me. So just to be sure, I called a friend of mine who use to work as a mortgage broker.
My first question to him was: “What’s in it for Wells Fargo? Why would they give me this deal?”
He explained that there was a dearth of new high-quality mortgages. Banks that issued mortgages needed good new mortgages to repackage and sell. I had a credit rating above 800. I had a job. I had never missed a mortgage payment and had a lot of equity in my home. I was a quality mortgagee.
Naturally, my second question was: “Who loses in this deal?”
One loser, he explained, was the investor(s) who owned the income stream from my original mortgage. By paying off my original mortgage early, I cut them off from 13 more years of 6%-plus interest payments.
Another loser could be the new investor(s) who bought my refinanced mortgage. After being used to high-income streams fueled by a high percentage of subprime loans, they would have to settle for far lower yields on their investments.
This is exactly what M-REITs are seeing. Remember, they invest in pools of mortgages. As mortgage rates fall, so does their income.
My refinance story — playing out across the country — is just one of the reasons why popular mortgage REITs such as Annaly Capital Management (NYSE: NLY) and American Capital Agency (Nasdaq: AGNC) have underperformed the market in the past months. Below is a chart of the Market Vectors Mortgage REIT ETF (NYSE: MORT) — a proxy for mortgage REITs — compared with the S&P 500 Index.
Despite paying yields as high as 19.1%, mortgage REITs have dramatically underperformed the market in the past few months.
Mortgage REITs may continue to struggle if rates for new and refinanced mortgages continue to remain low. And to top it off, the government just announced a new plan to help underwater homeowners refinance their mortgages. A move that could further hurt M-REITs.
Meanwhile, Annaly already cut its quarterly dividend to $0.60 from $0.65 per share. American Capital has been able to maintain its dividend for now. But I feel both dividends are more likely to see downward adjustments than to see growth.
Action to Take –> So though I think that someday these M-REITs will make a nice addition to my real-money portfolio within my Daily Paycheck advisory, for now I’m steering clear. Until the market cools and interest rates rebound, I think these high-yielding securities are better left alone.
P.S. — In the the latest issue of my premium newsletter, The Daily Paycheck, I tell my readers about a high-yield investment that’s much safer than M-REITs. To learn more about my advisory, and how StreetAuthority co-founder Paul Tracy made $112.77 a day in 2010 using my Daily Paycheck Strategy, make sure to visit this link now.