2 High-Yield Dividend Stocks to Buy If Fed Cuts Rates

The Federal Reserve is expected this week to approve the first of what will likely be several cuts in the prime lending rate over the next two years in its efforts to keep the US economy on an even keel. Perhaps no sector of that economy is set to benefit as much as the housing sector and, more specifically, mortgage REITs (real estate investment trusts).

In simple terms, mortgage REITs are specialized companies that invest in mortgage-backed securities, or MBS. Taking the explanation to another level, these REITs finance these MBS investments using short-term financing vehicles such as repos (repos), which they then hedge to better match the duration of the MBS they own Ultimately, they make money through the difference in interest rates between the cost of financing and the coupons of their MBS investments, which they further leverage.

The investment income generated by mortgage REITs is then mostly paid out to investors in the form of dividends (as required by the tax structure in which these REITs operate).

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Lower interest rates greatly benefit mortgage REITs

Mortgage REITs are typically valued based on the value of their MBS portfolios, which is reflected in their book value per share. Companies in this sector have had a tough few years as the Fed aggressively raised rates. MBS are fixed income securities, all of which are exposed to what is called interest rate risk.

This is simply the loss of market value of a fixed rate security, such as a bond, experiences where investors can get a higher coupon in a similar fixed rate security. For example, if an investor held a Treasury bond with a 4% coupon, they could not sell that bond at par and buy a new bond with a 6% coupon. Conversely, if they wanted to sell that bond before maturity, they would have to sell it at a discount based on similar bond yields.

Thus, when the Fed aggressively engaged in a rate hike campaign, the market value of the MBS held by the mortgage REITs lost value. Now, with the Fed cutting rates, these companies should start seeing their book values ​​improve.

In particular, mortgage REITs hedge their interest rate risk to a degree, so it’s not actually the biggest factor in changing the value of their portfolios. While companies have been hurt by higher interest rates, the yield spreads between government agency-backed MBS and Treasuries expansion have had the biggest impact on their portfolio values.

Going forward, spreads between government agency-backed MBS and Treasury tightening will have the largest positive impact on the value of mortgage REITs’ MBS portfolios and their stocks. And there is good reason to believe that spreads will begin to narrow as the Fed cuts rates.

Over the past few years, mortgage trading has generally been unattractive to banks and other institutions. There was no need for banks to go into MBS when mortgage rates were rising. Even after they stopped rising, the spread between short-term and MBS rates wasn’t that attractive. At the same time, some regional banks, such as SVB FinancialSilicon Valley Bank, ran into significant financial difficulties due to their unbalanced MBS portfolios.

With many banks and other buyers avoiding the MBS market, there was more supply of MBS, which in turn led to a widening of MBS spreads over Treasuries. Now, as the Fed cuts rates, the yield curve (the difference between short-term and long-term rates) should begin to slope, drawing more banks and other institutions into the MBS market. This, in turn, should narrow down what have historically been wide spreads over the past few years.

Two stocks ready to benefit

Two of the stocks most likely to benefit from this Fed tapering environment over the next few years are AGNC Investments (AGNC 0.28%) and Annaly Capital Management (NLY -0.14%). Both companies invest primarily in agency MBS, which carry virtually no credit risk because the mortgages are federally insured.

At the end of the second quarter, over 98% of AGNC’s portfolio was in agency MBS, with over 97% of the agency portfolio in 30-year fixed mortgages. Meanwhile, Annaly had 88% of the portfolio in the MBS agency. About 94% of its agency portfolio was in 30-year fixed MBS.

In its filings, AGNC indicated that based on its portfolio at the end of June, a 25 basis point reduction in the MBS-treasury spread would have a positive impact of 12.6% on its book value, in while a 50- basis point narrowing would have a positive impact of over 25%. That’s a little more benefit than Annaly would see.

Annaly said that based on a 15 basis point cut, its book value would improve by 6.2%, while a 25 basis point improvement would see its book value increase by 10 .4%.

AGNC stock is the slightly more expensive of the two, trading at 1.23 times book value, compared to 1.06 times for Annaly. AGNC has a yield of 13.9%, while Annaly has a yield of 12.7%.

While they have some slight differences, both stocks are set to benefit greatly from the Fed’s rate cut cycle and the likely narrowing of the Treasury MBS spread. Both stocks have robust yields of well over 12% and should see their book values ​​improve, leading to both strong dividend yields and good stock appreciation over the next few years as interest rates begin to rise to decrease. As such, I would be a buyer of both stocks.