Wall Street has been on a pedestal above all other asset classes for more than a century. While government bonds, housing, gold and oil have generated nominal returns for investors over the long term, none of these asset classes come close to the annualized total returns that stocks have delivered.
With thousands of publicly traded companies and exchange-traded funds (ETFs) to choose from, chances are Wall Street has one or more securities that can meet any investor’s goals. But overall, buying and holding high-quality dividend stocks over time is a strategy that’s hard to beat.
Last year, the investment advisors at Hartford Funds released a comprehensive report examining the essence of what makes dividend stocks such a great long-term investment. In particular, “The Power of Dividends: Past, Present and Future” looked at the outperformance of income stocks compared to nonpaying stocks over a fifty-year period (1973-2023).
Dividend payers achieved an annualized return of 9.17% over half a century, while they did so while they were at 6% fewer more volatile than the benchmark S&P 500Companies that pay regular dividends are typically profitable on a recurring basis and can provide investors with transparent long-term growth prospects.
On the other hand, non-payers generated a more modest annual return of 4.27% over the same 50-year period, and did so while holding 18% of the total debt. more more volatile than the S&P 500.
While dividend stocks have a history of outperformance, not all income stocks are created equal. For example, studies have shown that risk and return often correlate. This means that ultra-high yield dividend stocks — those with yields four or more times those of the S&P 500 — can occasionally be more trouble than they’re worth. But this is not always true.
Right now, two extremely high-yielding dividend stocks (13.86% average yield) from what is perhaps the most hated sector on Wall Street are ripe for the picking.
Say hello to Wall Street’s most universally hated industry
While there are quite a few sectors that Wall Street analysts have lukewarm opinions about, I’m fairly certain that no sector has become as universally disliked in the past decade as mortgage real estate investment trusts (REITs).
Mortgage REITs are companies that seek to borrow money at lower short-term interest rates and use this capital to purchase higher-yielding long-term assets such as mortgage-backed securities (MBS). This is how the industry got its name (“mortgage REITs”). The difference between the average return on owned assets minus the interest rate is known as the ‘net interest margin’. The higher the net interest margin, the more profitable the mortgage REIT.
The thing about mortgage REITs is that they very sensitive to changes in interest rates and the speed at which the Federal Reserve makes changes to its monetary policy.
Mortgage REITs tend to perform best in low/falling interest rate environments, with the country’s central bank making slow, calculated changes to monetary policy that are well advertised to investors. Starting in March 2022, the Fed undertook its most aggressive rate hike cycle since the early 1980s. This was a double blow for mortgage REITs, as short-term borrowing costs rose rapidly and the country’s central bank failed to properly announce this.
To make matters worse, the Treasury yield curve is in the midst of the longest inversion of the modern era. That is, Treasury bills maturing in a year or less have higher yields than bonds maturing in 10 or 30 years. An inverted yield curve tends to reduce the net interest spread for mortgage REITs and lowers the book value of the assets they hold.
Declining book value can be particularly bad news for mortgage REITs, as their stock price often fluctuates very close to reported book value each quarter.
With mortgage REITs facing so many headwinds, it’s not hard to understand why Wall Street has such a negative view of the sector.
But just when the situation for mortgage REITs appears worst, that’s when investors should consider making a move.
Time to strike: Annaly Capital Management (12.97% return) and AGNC Investment (14.75% return)
Of the more than three dozen publicly traded mortgage REITs, it’s the two largest (by market cap) that are emerging as the best buys right now. I’m talking about Annaly Capital Management (NYSE: NLY) And AGNC investment (NASDAQ: AGNC).
Annaly has declared $25 billion in dividend payments to its investors since becoming a publicly traded company in October 1997, while AGNC Investment pays its dividend monthly. Most importantly, Annaly has averaged returns of around 10% over the past two decades, with AGNC maintaining double-digit returns in 13 of the past 14 years.
One of the key factors working in Annaly and AGNC’s favor is that the Fed appears to have reached a tipping point. While core inflation (looking at you, housing costs!) remains stubbornly above the Fed’s long-term 2% target, the central bank appears to be leaning toward rate cuts at this point, not additional rate hikes. Rate cut cycles have historically given mortgage REITs the opportunity to outperform.
More importantly, the country’s central bank is taking its time. The slow implementation of changes in monetary policy allows Annaly and AGNC to adjust their investment portfolios to maximize their profit potential. If these changes happen too quickly, neither company will be able to make these adjustments. Even if interest rates remain above historical norms in the coming quarters, the simple fact that the Fed remains steadfast is enough to allow Annaly and AGNC to find their footing.
Another thing worth mentioning is that the country’s central bank has ended its quantitative easing program, which involved MBS purchases. With the deep-pocketed Fed out of the picture, the two biggest names in mortgage REITs face less competition in purchasing higher-yield MBSs. Keep in mind that while higher interest rates have increased short-term borrowing rates, the returns Annaly and AGNC receive on the MBSs they buy have also increased significantly. Over time, this dynamic should help expand the duo’s net interest margin.
History is also on the side of these two titans. While no one knows when the current yield curve inversion will end, history shows that the Treasury yield curve tends to slope upward and to the right for a disproportionate amount of time, with longer-term bonds having higher yields than Treasury bills that mature in just a few months . As the yield curve normalizes, Annaly and AGNC should see notable improvements in their respective net interest margin and book value.
The final reason for investors to pile into these ultra-high-yield income stocks is that Annaly Capital Management and AGNC Investment have tailored their respective portfolios to maximize profits and protect their capital. They do this by focusing on agency assets.
An “agency” asset is backed by the federal government in the event of a default on the underlying asset. Annaly ended March with 88% of its $73.5 billion investment portfolio in highly liquid agency assets. Meanwhile, all but $1.1 billion of AGNC’s $63.3 billion investment portfolio was tied up in agency securities at the end of the first quarter.
While this additional protection reduces the yield these mortgage REITs receive on the MBSs they purchase, it allows them to cautiously leverage their investments to maximize profits. This leverage is what allows Annaly and AGNC to maintain their respective yields of 13% and 14.8%.
After years of underperformance, Annaly and AGNC appear poised to shine for patient money seekers.
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Sean Williams holds positions at Annaly Capital Management. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
Time to Pounce: 2 Ultra-High Yielding Dividend Stocks in Wall Street’s Most Hated Sector That Are Begging to Be Bought Right Now originally published by The Motley Fool
