Stocks were rebounding Tuesday, but are investors really safe from roiling markets?
For investors spooked by the August swoon, real estate investment trusts might offer some refuge with their double-digit dividend yields. Mortgage REITs, in particular, are offering the loftiest yields - with some exceeding 19%.
Although mortgages REIT have also fallen - posting negative returns of 4% in 2015 - it certainly sounds better than the S&P 500 I:GSPC that lost 1.3% on Tuesday, extending its three-month decline to 12%.
REITs are generally collections of income-producing real estate and mortgage securities that are packaged together as investment vehicles. Jittery investors can park their cash in REITs, and collect a handsome dividend while riding out the insecurity of stock market volatility.
That's the theory anyway, and oftentimes it's also the practice. Nonetheless, REITs, like any investment tool contain risks.
"There's no such thing as safe returns - You don't earn a double-digit yield or a 19% yield without taking on risk," cautioned Michael Widner, director of equity research at Keefe, Bruyette & Woods. "So, it's a question of trying to find places where the market may be overestimating the risk."
This means picking individual REIT names to find the safest bets.
Widner likes Investco Mortgage Capital (IVR) - Get Report , whose dividend yield is currently 13.1%, and CYS Investments (CYS) , whose yield is 14.5%. Investco's low valuation and diversity make it attractive while CYS's focus on mortgage securities backed by Fannie Mae and Freddie Mac does the same.
Annaly Capital Management (NLY) - Get Report and American Capital Agency (AGNC) - Get Report are a pair of REITs that Brock Vandervliet of Nomura Securities recently upgraded to buy from neutral. Both have an upside potential of 19%, he said, while including a dividend, that works out to a more than 30% total returns. Annaly also recently launched a $1 billion share buyback program, helping to boost the shares.
Annaly currently offers an 11.7% dividend yield while American Capital has a 12.3% yield.
REITs, in general, have taken a hit over the past few quarters as investors fretted over when - and how much - the Federal Reserve would ultimately raise rates. Mortgage REITs borrow money based on short-term rates, and then use the cash to buy long-term bonds. The bigger the gap - or spread - between the funding costs and the yields on the mortgages they purchase, the bigger the profit. But, as rates rise, bond prices fall, which means the mortgage REIT gets a double-whammy of higher borrowing costs and lower yields on the mortgage securities it holds.
When this happens, a REIT may opt to trim its dividend or even suspend it. And that's the danger investors potentially face if they buy into this group solely for the lofty dividend yield.
But some experts believe the rate risks have been overblown and are already priced into certain beaten-down REIT stocks. The country's sluggish economic recovery, cheap oil prices and low inflation don't justify big rate hikes, experts say. They predict the Fed will move slower and bring in smaller rate hikes than in past cycles. This would prevent REIT book values from tanking.
Yet, some of the stocks "have been priced like we're about to enter a 1994 hiking cycle - when that was almost never in the cards," said Jason Weaver, a senior vice president at Sterne Agee.
Mortgage REITs, which hold mortgage securities on properties, currently offer a dividend yield of 11.4% on average, according to the National Association of Real Estate Investment Trusts. This outpaces the S&P 500's dividend yield of 2.1%, the Dow Jones Industrial Average's 2.6%, the Nasdaq 100's 1.3%, and the 10-year treasury yield of 1.962%.
Still, there are skeptics who think investors are crazy to look at dividend yields as a reason to invest. "REITs aren't like a bond - the dividend isn't guaranteed over time," said Andy McCulloch, a managing director at Green Street Advisors, a REIT research firm in Newport Beach, Calif. "If something happens in the overall economy, where cash flow gets hurt, that dividend can go down or be suspended outright."
And those with the loftiest dividends, in general, pose the highest risk.
The mortgage REITs with the biggest dividend yields are Western Asset Mortgage Capital (WMC) - Get Report , which has a 19.3% yield, Orchid Island Capital (ORC) - Get Report , which has a 20% yield, Five Oaks Investment (OAKS) , which offers a 17.8% yield, and Armour Residential REIT (ARR) - Get Report , which has an 18.2% yield.
"Why is something paying you a 19% dividend yield when there's fear in the market?" asked Michael Torres, chief executive of Adelante Capital Management LLC.
"The stated yield when you buy [mortgage REITs] may be attractive, but you may lose on the capital side" when you sell them, he said. "Prices are going down - and going down dramatically - and pigs get slaughtered."
This article is commentary by an independent contributor. At the time of publication, the author held TK positions in the stocks mentioned.