Markets

These High-Yielders Generate 2 Types Of Value

There are several ways to define value, but our favorites typically offer juicy income streams or a deep wellspring of net assets that are actually worth more than the share price.

It's nice to find stocks that offer high dividend yields or trade below book value, but one group of stocks checks both boxes. Value squared, if you will.

I'm talking about the mREITs (mortgage real estate investment trusts), which buy mortgages at a discount to their face value. You already know the sector is cheap when you see these kinds of dividend yields.

And the view sharpens once you look at their balance sheets. Every one of these mREITs trades for less than tangible book value.

As a quick recap, these mREITs borrow low-rate, short-term debt and use the funds to buy bonds consisting of pools of mortgages guaranteed by government-sponsored giants and . They also use leverage to amplify their profits.

As a quick recap, these mREITs borrow low-rate, short-term debt and use the funds to buy bonds consisting of pools of mortgages guaranteed by government-sponsored giants Fannie Mae ( FNMA ) and Freddie Mac ( FMCC ) . They also use leverage to amplify their profits.

The borrow-to-buy strategy worked like a charm in the years after the Great Recession, as mortgage bonds sold at very low prices on fears of a further housing slump. As the housing market has stabilized, the mortgage bonds no longer trade on the cheap, so these mREITs no longer deliver outsized returns on their portfolio.

Let's use Two Harbors (NYSE: TWO ) as an example. Its portfolio of bonds has grown ever larger, but thinner profit spreads means the dividend growth hasn't been as impressive.

Two Harbors

In fact, the inability to find sharply discounted mortgage bonds at this stage of the economic cycle is likely to push the dividend to just $1.04 a share in 2014 and 2015, according to analysts at Merrill Lynch.

But that payout looks to be quite safe, especially as Two Harbors makes a push into other niches, such as mortgage servicing rights (MSRs), which generate respectable cash flow regardless of the price of mortgage bonds or a move in interest rates. Merrill Lynch thinks "TWO remains a compelling investment opportunity given its strong expected returns and potential for upside afforded by new investment opportunities (such as MSRs).

Analysts at BMO capital are also a fan of TWO: "We prefer the mortgage REITs that are building out operating businesses, which we see as being rewarded with premium valuations over time. TWO is our top pick (among the securities-focused REITs) given the combination of attractive risk/reward of the securities book coupled with the build out of the MSR and jumbo conduit businesses."

The key for such stocks is to think of them in the context of total return. Two Harbors trades at just a slight discount to book, so most of the return will come from that nearly 10% dividend yield. Other operators that trade well below tangible book value offer a different setup. Hatteras Financial (NYSE: HAT ) has 18% upside just to return to tangible book value. Toss in the 10% dividend yield, and you are looking at a 28% potential total return.

Regarding those juicy prospective yields, investors should understand that they generally reflect the perceived risk of rising interest rates. The mREITs that hold bonds most likely to fall in value if interest rates rose sharply tend to be the highest yielders.

A lower yielder, such as Two Harbors, represents much lower rate risk, in part to rate-hedging strategies, which is why this REIT seems to be a favorite of many analysts who follow the group. Then again, if rates do not rise over the next year or two, then it's those highest yielders that may become the strongest sector performers. CYS Investments (NYSE: CYS ) is the best REIT to own if you expect rates to stay at current levels.

If investors want to own a broad spectrum of these REITs, they can invest in the iShares FTSE NAREIT Mortgage REITs Index Fund ETF (NYSE: REM ) , which carries a 30-day SEC yield of 9.9% and a 0.48% expense ratio.

Risks to Consider: Interest rate moves are the biggest potential headwind, which might cause some stated book values to shrink as portfolio valuations are written down. The other potential headwind is a rise in mortgage defaults, which seems less likely to happen as we move further away from the housing crisis.

Action to Take --> If interest rates rise, then these mREITs would exit the rate-hike process with fresh wide spreads to again pursue their borrow-to-buy strategy. So this isn't merely a built for the post-recession industry, as some had previously thought.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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