2 ultra-high yielding dividend stocks with 12% plus yields that are ideally positioned for a rate cut cycle

One of the best things about putting money to work on Wall Street is that there is no one-size-fits-all approach to investing. With thousands of publicly traded companies and exchange traded funds (ETFs) to choose from, there is bound to be one or more securities that can help you achieve your goals.

But among the countless ways to build wealth on Wall Street, few strategies have proven more successful than buying and holding high-quality dividend stocks.

The appeal of dividend stocks is simple: they are almost always profitable and time-tested. A company that regularly distributes a percentage of its profits is one that investors rarely have to worry about when they go to bed at night.

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More importantly, dividend stocks have absolutely crushed the defaulters in the return column for the past 50 years. A report released last year by investment advisors at Hartford Funds (The Power of Dividends: Past, Present and Future) compared the performance of income stocks with those of defaulters over the past half century (1973–2023). What Hartford Funds, in conjunction with Ned Davis Research, found is that income stocks more than doubled the average annual return of defaulters — 9.17% versus 4.27% — over this period.

But that doesn’t mean investors can throw a dart at the newspaper and pick a winner. All dividend stocks are unique and ultra-high-yield companies (those with yields four or more times S&P 500) often come with additional risk. Because yield is a function of share price, a company with a failed business model can “catch” revenue seekers with a profitable but unsustainable yield.

But not all supercharged high-yield stocks are worth avoiding. With the Federal Reserve kicking off a rate easing cycle this week, two income stocks with eye-popping yields of 12.5% ​​and 13.9% are perfectly positioned to thrive.

The light at the end of the tunnel has arrived for Wall Street’s most hated industry

While “worst” is a bit of a subjective term, there probably hasn’t been an industry that analysts have disliked for a longer period of time than mortgage real estate investment trusts (REITs).

Mortgage REITs are companies that aim to borrow money at lower short-term borrowing rates and use that capital to purchase longer-term, higher-yielding assets such as mortgage-backed securities (MBS), so how the industry got its name. The goal of mortgage REITs is to maximize their net interest margin, which is the average return on the assets they hold less the average short-term borrowing costs.

The Fed’s 525 basis point rate hike cycle, which began in March 2022, was the fastest in four decades. Actual Federal Funds Rate Data by YCharts.

As you may have gathered, the mortgage REIT industry is very sensitive to changes in interest rates. When the nation’s central bank began its steepest rate hike cycle in four decades in March 2022, it sent short-term borrowing costs soaring. The result for the mortgage REIT industry has been reduced net interest margin.

And it’s not just higher interest rates that need to worry the industry. The speed at which monetary policy moves also matters. If the Federal Reserve makes slow, calculated and well-telegraphed moves, mortgage REITs have the opportunity to reposition their assets to maximize returns. But with the Fed eyeing a four-decade peak in the rate of headline inflation, slowing its rate-hike cycle is quickly out the door.

Almost every publicly traded company in the mortgage REIT industry has seen its book value decline — most mortgage REITs trade very close to their respective book values ​​– and net interest margin has narrowed since March 2022.

However, the light at the end of the tunnel has finally arrived for Wall Street’s most hated industry. Annaly Capital Management (NLY 0.53%) and AGNC Investments (AGNC 0.95%)which show respective returns of 12.5% ​​and 13.9%, now have an excellent chance to outperform.

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Annaly and AGNC are ideally positioned to thrive during a rate cut cycle

With the headline inflation rate easing to 2.5% in August, the lowest reading seen since February 2021, the nation’s central bank was given all the incentive in the world to undertake a rate easing cycle.

When the Fed switches to accommodative monetary policy and lowers the federal funds rate, it tends to reduce the cost of short-term borrowing and allows the net interest margin for Annaly and AGNC Investment to expand. At the same time, these two top mortgage REITs have been able to acquire higher yielding MBS over the past couple of years, which may provide further growth to their respective net interest margins.

Equally important, the Fed is currently walking on eggshells in terms of monetary policy. After leaving federal funds rates at historic lows for too long and, in retrospect, overshooting them in the wake of high inflation, the Federal Open Market Committee is likely to slow down any further changes. Well-telegraphed moves will allow Annaly and AGNC to position their portfolios for optimal success.

A cycle of rate easing is also expected to lead to an eventual normalization of the yield curve.

Normally, the Treasury yield curve is upward sloping and to the right. This means that bonds with longer maturities that are due in more than 30 years have higher yields than T-bills that will mature in a year or less. We recently witnessed the longest yield curve inversion in history, with short-term yields easily outperforming long-term bonds. When the yield curve flattens, mortgage REITs shine.

The last piece of the puzzle for Annaly Capital Management and AGNC Investment is that they invest predominantly in agency securities. An “agency” asset is one that is backed by the federal government in the unlikely event of default.

Annaly ended the quarter ending in June with $66 billion of its $74.8 billion portfolio tied to highly liquid agency assets, while AGNC had nearly $1 billion of its $66 billion portfolio allocated to MBS and various agency securities. The added protection that Annaly and AGNC enjoy from agency securities allows both companies to prudently use their portfolios to maximize returns and support their huge dividends.

Although both companies have underperformed in the current bull market, Annaly and AGNC seem poised for their moment in the spotlight.