Capitalism Stock Certificate 2011

In this continuing series exploring different ways investors might attempt to increase the annual income received from their portfolios, we look at mortgage real estate investment trusts (REITs). A REIT is a security that sells like a stock and invests in real estate either through income-producing properties (equity REITs) or mortgage-backed securities (mortgage REITs). Index Funds Advisors, Inc. has long recommended an exposure to equity REITs via index funds as part of an overall investment in Capitalism, Inc. Mortgage REITs, however, are a different animal altogether. While there is nothing wrong with mortgage-backed securities per se, they are preferably used by institutions such as insurance companies that have a fair understanding of the risks they entail such as prepayment risk. The essential problem with mortgage-backed REITs is their extensive use of leverage which substantially increases both the dividend yield and the risk of a catastrophic loss. The potential pitfalls of leverage are further explained here

An example of a well-known mortgage REIT that relies heavily on leverage is Annaly Capital Management, Inc. (NLY). It currently has a dividend yield of 14.85% which may sound extraordinarily tempting so some investors, but as always, there is no such thing as return without risk. In this case, the risk is encompassed in a financial leverage ratio of 7.22 to 1 which explains why Morningstar assigns a financial health grade of “D” to NLY. If 14.85% isn’t a high enough yield, risk-seeking investors may opt for American Capital Agency Corp. (AGNC) which yields a stunning 19.63% and carries a breathtaking leverage ratio of 9.52 to 1. The leverage ratio is a measure of how many additional dollars borrowed by the fund per dollar invested in the fund. Leverage allows the fund to offer a high dividend yield as long as the rate of return earned on the underlying investments exceeds the interest charged by the lenders. In the event of an economic shock such as a sudden increase in interest rates, the fund may not be able to both cover its loss and re-pay the lenders. At that point, investors will be living in Jim Cramer’s House of Pain.