The Federal Reserve Bank of Richmond warned last year that investors in mortgage REITs "face significant risks on a number of fronts," and those risks haven't gone away.
Still, if the broader stock market goes sideways -- and given that the S&P 500 is up 16.5% over the last 12 months in a middling economy, you would be wise to question how much higher it can go in the near term -- mortgage REITs will continue to deliver outsized dividends until the Federal Reserve starts raising interest rates.
Annaly yields 11% and AGNC yields 12.15%, making them among the highest yields in the sector. That, coupled with the fact that they are also among the largest mortgage REITs, is why they are the most widely followed.
Still, Keefe Bruyette & Woods analyst Michael Widner, who calls himself "on the positive side of neutral" with regard to the whole sector, prefers AGNC when it comes to those two names. In addition to AGNC, he has outperform ratings on Hatteras Financial (HTS) Two Harbors Investment Corp. (TWO - Get Report) and MFA Financial (MFA) , among several others in the sector.
Mortgage REITs borrow very short term -- typically taking out 30-day loans -- and they invest those loans in longer-dated mortgage-backed securities and, in some cases, secondary mortgages. They then use those MBS as collateral to repeat the process -- borrowing short term and buying longer-dated MBS. They execute this process several times, allowing them to pay dividends that often yield in the double digits.
All that short-term borrowing, in addition to high leverage, is what makes mortgage REITs so scary. Those are the same things that characterized Lehman Brothers and Bear Stearns in 2008, just before they collapsed.
That risk is the reason some analysts are bearish on the sector. In a Sept. 3 note, Goldman Sachs analysts called the "risk-reward still unfavorable," for mortgage REITs. Since that time, however, Annaly shares have fallen 7.54% and AGNC shares are down 9.3%.
If you wait for Goldman to upgrade the sector, you'll be too late. Of course, if the market perceives the Fed as raising interest rates sooner than expected, mortgage REITs have a lot further to fall.