For over a century, Wall Street has stood on a pedestal above all other asset classes. Although Treasury bonds, real estate, gold, and oil have generated nominal profit for investors over the long term, none of these asset classes come remotely close to the annualized total return that stocks have generated.
With thousands of publicly traded companies and exchange-traded funds (ETFs) to choose from, chances are Wall Street has one or more stocks that can meet any investor’s goals. But when you look at the big picture, buying and holding high-quality stocks dividend stocks over an extended period of time is a difficult strategy to surpass.
Last year, investment advisors Hartford Funds released a lengthy report examining the details of what makes dividend stocks such a good long-term investment. In particular, “The Power of Dividends: Past, Present and Future” discussed the outperformance of income stocks relative to non-payers over a 50-year period (1973-2023).
Dividend payers generated an annualized return of 9.17% over half a centuryand this, while being at 6% less volatile than the benchmark index S&P 500. Companies that pay a regular dividend are generally profitable on a recurring basis and able to provide investors with transparent long-term growth prospects.
In contrast, non-payers generated a more modest annualized return of 4.27% over the same 50-year period, while at 18%. more volatile than the S&P 500.
While dividend stocks have a track record of outperformance, not all income stocks are created equal. For example, studies have shown that risk and return tend to be correlated. That means that very high-yielding dividend stocks—those with yields four or more times those of the S&P 500—can sometimes be more trouble than they’re worth. But that’s not always true.
Right now, two ultra-high-yielding dividend stocks — boasting an average yield of 13.86% — in what is arguably Wall Street’s most hated industry are ripe for the picking.
Say hello to Wall Street’s most universally hated industry
While there are a number of industries that Wall Street analysts have mixed opinions on, I’m fairly confident that no industry has been more universally hated over the past decade than real estate investment trusts mortgage (REIT).
Mortgage REITs are companies that aim to borrow money at lower short-term rates and use that capital to purchase higher-yielding, long-term assets, such as mortgage-backed securities (MBS). ). This is how the sector got its name (“Mortgage REITs”). The difference between the average return generated by the assets held and their borrowing rate is known as the “net interest margin.” The higher the net interest margin, the more profitable the mortgage REIT generally is.
The problem with mortgage REITs is that they are very sensitive to changes in interest rates, as well as the speed with which the Federal Reserve implements changes in its monetary policy.
Mortgage REITs tend to perform better in low or falling rate environments, when the country’s central bank makes slow, calculated changes to monetary policy that are well publicized to investors. Starting in March 2022, the Fed undertook its most aggressive rate hike cycle since the early 1980s. This was a double whammy for mortgage REITs, as borrowing costs in the short term have increased rapidly and the country’s central bank has not well announced this decision.
To make matters worse, the Treasury yield curve is in the midst of its longest inversion in modern times. That means Treasuries maturing in a year or less are carrying higher yields than bonds maturing in 10 or 30 years. An inverted yield curve tends to reduce the net interest margin of mortgage REITs, as well as reduce the book value of the assets they hold.
The decline in book value can be bad news for mortgage REITs, given that their stock prices often hover very close to their reported book value each quarter.
With mortgage REITs facing a mountain of headwinds, it’s easy to understand why Wall Street has such a negative perception of the sector.
However, it’s precisely when things look bleak for mortgage REITs that investors should consider jumping in.
Time to pounce: Annaly Capital Management (12.97% yield) and AGNC Investment (14.75% yield)
Among more than three dozen publicly traded mortgage REITs, these are the two largest (in terms of market cap) that currently stand out as best buys. I’m talking about Annaly Capital Management (NYSE:NLY) And AGNC Investment (NASDAQ: AGNC).
Annaly has declared $25 billion in dividends to its investors since going public in October 1997, while AGNC Investment distributes its dividends on a monthly basis. More importantly, Annaly has averaged a return of around 10% over the past two decades, with AGNC maintaining a double-digit return 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 an inflection point. While core inflation (I’m looking at you, housing spending!) remains stubbornly above the Fed’s long-term target rate of 2%, the central bank currently appears to be leaning toward rate cuts, not further rate hikes. Rate-easing cycles have historically given mortgage REITs an opportunity to outperform.
More importantly, the country’s central bank is taking its time. The slow implementation of monetary policy changes 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 for several quarters to come, the simple fact that the Fed is not budging is enough to allow Annaly and AGNC to find their footing.
It is also worth noting that the country’s central bank ended its quantitative easing program which involved purchases of MBS. With the exclusion of the deep-pocketed Fed, the two biggest names in mortgage REITs have less competition when purchasing high-yield MBS. Keep in mind that while rising interest rates have increased short-term borrowing rates, the yield that Annaly and AGNC receive on the MBS they purchase has also increased significantly. Over time, this dynamic should help expand the duo’s net interest margin.
History also works in favor of these two titans. Although no one knows when the current yield curve inversion will end, history shows us that the Treasury yield curve spends a disproportionate amount of time tilting up and to the right, with longer-term bonds carrying higher yields than Treasuries maturing 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 investors are flocking to these high-yielding stocks is that Annaly Capital Management and AGNC Investment have oriented their respective portfolios to maximize profits and protect capital. They do this by focusing on agency assets.
An “agency” asset is guaranteed by the federal government in the event of a default on the underlying security. Annaly closed 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 various agency securities at the end of the first quarter.
Although this additional protection reduces the return these mortgage REITs receive on the MBS they purchase, it allows them to prudently leverage their investments to maximize profits. It is this leverage that can allow 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 revenue-seeking patients.
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Sean Williams holds positions with 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-Yield Dividend Stocks in Wall Street’s Most Hated Sector That Are Worth Buying Now was originally published by The Motley Fool
