Dump These 3 High-Yield Stocks Fast as the Yield Curve Flattens

Real Estate Investment Trusts (REITs), Stocks to Avoid, The Fed

After a decade of zero percent short term rates, in 2016 the Federal Reserve Board started to increase its Fed Funds Rate, which is the rate that drives all short term interest rates. That rate is now effectively 2.5%.

Over the same period, rates at the longer end of the yield curve have not risen as much and the 10-year yield now stands at 2.5%. We effectively have a flat yield curve.

The financial news coverage seems to shift daily between the dangers of a flat yield curve and the dangers of a rising yield on the 10-year Treasury. These two outcomes are quite mutually exclusive, but either scenario is a danger to the finance REITs that own large portfolios of residential mortgage securities.

These high-yield stocks are not the place to gamble on the direction of future interest rates. Losing that bet will cost you more than you are likely willing to lose.

Residential mortgage REITs buy what are called residential mortgage backed securities (MBS), which are bonds backed by pools of residential mortgages. The majority of residential MBS hold loans are guaranteed by one of the governmental agencies, like Fannie Mae, Freddie Mac, and Ginnie Mae.

With the agency backing, these mortgage securities have AAA credit ratings. The top rating gives investors owning the bonds safety of principal, but also result in low yields on the bonds. For example, agency 30-year mortgage MBS currently yield around 3.1%.

It takes large amounts of leverage for one of these REITs to pay 10% or 12% dividend yields. By leverage I mean a REIT borrows money to buy MBS bonds. These companies will leverage their equity 5 to 8 times or more, and most of the cash to pay dividends comes from the difference between the yields on the MBS and the short term borrowing costs.

As the yield curve flattens, the interest rate spread on which a residential MBS REIT depends will shrink. A tightening spread can quickly reduce cash flow, a flat yield curve means no money to pay dividends, and an inverted yield curve means big losses for the REIT.

The other potential challenge is rising long term interest rates. If this happens, the market prices of MBS bonds will fall.

Lenders providing the leverage will force the REITs to sell bonds at a loss. The result is a shrinking portfolio which means less interest income flowing into the business to cover expenses and dividend payments.

The agency residential MBS REIT business model needs the Goldilocks scenario of a positively sloped yield curve and interest rates that are stable to declining.

Here are three agency MBS REITs whose futures will be negatively affect by current interest rate forecasts.

AGNC Investment Corp (Nasdaq: AGNC) is one of the largest agency MBS REIT. NLY and AGNC are the two largest companies in this REIT sector.

As of the 2019 first quarter AGNC owned $93.5 billion of agency MBS. This works out to 9.4 times leverage of the company’s equity. Over the last year, leverage was increased to 8.4 from 8.2 to account for the flatter yield curve.  The company had $86.3 billion of debt.

AGNC also earns dollar roll income in the MBS TBA (to be announced) mortgage trading. At the end of the quarter the company had a $7.0 billion TBA position Reported net interest spread for the quarter was 1.00%. A year earlier the spread was 1.26%, and 1.51% the year before that. This narrowing shows the effects of a flattening yield curve.

The company report net spread and dollar roll income of $0.54 per share and paid dividends of $0.54 per share. AGNC has zero cushion against higher short-term rates.

AGNC has reduced the dividend three times in the last three years to stay ahead of fallen net interest income.

Annaly Capital Management, Inc. (NYSE: NLY) is an agency MBS owning REIT that has an almost equal market cap to AGNC.

In its 2019 first quarter earnings report the company owned $105.0 billion worth of mortgage securities. Of this total, $103 billion was agency MBS. The company owns $9 billion of other assets, including $5 billion of commercial property mortgages. This large pile of assets is held aloft by a total of $96.4 billion of debt, resulting in 7.0 times leverage ratio.

In the quarter, Annaly reported a net interest rate margin of 1.25%, down from 1.52% a year earlier. That margin resulted in core earnings of $0.25 per share for the quarter. The current dividend is $0.30 per quarter.

The company actively hedges its interest rate risk and has been diversifying its business lines. However, this company is largely dependent in its leveraged agency MBS portfolio and hedging can only protect for slow changes in interest rates.

Management has announced a dividend reduction for the next quarter.

Arlington Asset Investment (AI) is a finance real estate investment trust (REIT). The company recently —at the end of 2018—converted to REIT status. The change did not have a material effect on how the company operates.

The company’s business model is to own a leveraged portfolio of U.S. government agency mortgage backed securities (MBS).

Arlington Asset Investment has a few additional challenges compared to its peers. Most are related to the company’s small $280 million market cap and $4.0 billion portfolio. The company uses significantly more leverage than other agency MBS REITs.

Most are levered 6 to 8 times, vs. the 10 times used by Arlington. More leverage equals more risk. Management expenses are very high. 2018 G&A expenses of $13.37 million were 5% of equity. That is a heavy load that must be overcome by the excessive use of leverage.

This stock is not worth the 20% yield.

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