The light at the end of the tunnel is getting brighter for two supercharged income stocks sporting a 13.86% average yield.
For more than a century, Wall Street has stood on a pedestal above all other asset classes. Although Treasury bonds, housing, gold, and oil have generated a nominal profit for investors over the long run, none of these asset classes comes remotely close to matching the annualized total return that stocks have delivered.
With thousands of publicly traded companies and exchange-traded funds (ETFs) to choose from, there's a good chance Wall Street has one or more securities that can satisfy any investors' goals. But when examined as a whole, buying and holding high-quality dividend stocks over an extended timeline is a strategy that's difficult to top.
Last year, the investment advisors at Hartford Funds released a lengthy report that examined the nuts-and-bolts of what makes dividend stocks such a great long-term investment. In particular, "The Power of Dividends: Past, Present, and Future" touched on the outperformance of income stocks when compared to non-payers over a 50-year stretch (1973-2023).
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Dividend payers delivered a 9.17% annualized return over a half-century, and did so while being 6% less volatile than the benchmark S&P 500. Companies that pay a regular dividend are usually profitable on a recurring basis and able to offer investors transparent long-term growth outlooks.
On the other hand, non-payers generated a more modest 4.27% annualized return over the same 50-year period, and did so while being 18% more volatile than the S&P 500.
While dividend stocks have a history of outperformance, not all income stocks were created equally. For example, studies have shown that risk and yield tend to correlate. This means ultra-high-yield dividend stocks -- those with yields that are four or more times greater than the S&P 500's yield -- can occasionally be more trouble than they're worth. But this doesn't always hold true.
Right now, two ultra-high-yield dividend stocks -- sporting an average yield of 13.86% -- in what's arguably Wall Street's most-hated industry are ripe for the picking.
Say hello to Wall Street's most universally disliked industry
Though there are quite a few industries Wall Street analysts have lukewarm opinions of, I'm fairly confident that no industry has been more universally disliked over the trailing decade than mortgage real estate investment trusts (REITs).
Mortgage REITs are businesses that aim to borrow money at lower short-term rates and use this capital to purchase higher-yielding long-term assets, such as mortgage-backed securities (MBS). This is how the industry got its name ("mortgage REITs"). The difference between the average yield generated on owned assets less their borrow rate is known as "net interest margin." The higher the net interest margin, typically the more profitable the mortgage REIT.
The thing about mortgage REITs is that they're highly sensitive to moves in interest rates, as well as the velocity by which the Federal Reserve implements changes to its monetary policy.
This is the longest yield-curve inversion of the modern era. 10 Year-3 Month Treasury Yield Spread data by YCharts.
Mortgage REITs tend to perform their best during low/declining-rate environments where the nation's central bank is making slow, calculated changes to monetary policy that are being well-telegraphed to investors. Beginning in March 2022, the Fed undertook its most-aggressive rate-hiking cycle since the early 1980s. This was a double whammy for mortgage REITs in that in rapidly increased short-term borrowing costs and wasn't well-telegraphed by the nation's central bank.
To make matters worse, the Treasury yield curve is in the midst of its longest inversion of the modern era. This is to say that Treasury bills set to mature in a year or less are sporting higher yields than bonds maturing in 10 or 30 years. An inverted yield curve tends to narrow the net interest margin for mortgage REITs, as well as reduces the book value of the assets they hold.
Declining book value can be particularly bad news for mortgage REITs given that their share price often hovers very close to reported book value each quarter.
With mortgage REITs navigating a mountain of headwinds, it's easy to see why Wall Street has such a negative perception of the industry.
However, when things seem their grimmest for mortgage REITs is precisely when investors should consider pouncing.
Image source: Getty Images.
Time to pounce: Annaly Capital Management (12.97% yield) and AGNC Investment (14.75% yield)
Among the more than three dozen publicly traded mortgage REITs, it's the two largest (by market cap) that stand out as the best buys right now. I'm talking about Annaly Capital Management (NLY 0.32%) and AGNC Investment (AGNC 0.62%).
Annaly has declared $25 billion in dividend payments to its investors since becoming a public company in October 1997, while AGNC Investment doles out its dividend on a monthly basis. Most importantly, Annaly has averaged around a 10% yield over the last two decades, with AGNC maintaining a double-digit yield in 13 of the last 14 years.
One of the key factors working in Annaly's and AGNC's favor is that the Fed appears to have hit an inflection point. Although core inflation (looking at you, shelter expenses!) remains stubbornly above the Fed's long-term target rate of 2%, the central bank appears to be leaning toward rate cuts, not additional rate hikes, at this point. Rate-easing cycles have historically given mortgage REITs an opportunity to outperform.
More importantly, the nation's central bank is taking its time. The slow implementation of changes to monetary policy allows Annaly and AGNC to adjust their investment portfolios in order to maximize their profit potential. If these changes happen too quickly, neither company can make these adjustments. Even if interest rates remain above historic norms for multiple quarters to come, the simple fact that the Fed is standing pat is enough to allow Annaly and AGNC to find their footing.
Something else worth noting is that the nation's central bank has ended its quantitative easing program that involved MBS purchases. With the deep-pocketed Fed out of the picture, the two biggest names in mortgage REITs have less competition when purchasing higher-yielding MBSs. Keep in mind that while higher interest rates have increased short-term borrowing rates, the yield Annaly and AGNC receive on the MBSs they're purchasing has also meaningfully risen. Over time this dynamic should help widen the duos net interest margin.
History is also on the side of these two titans. Although no one knows when the current yield-curve inversion will end, history shows us that the Treasury yield curve spends a disproportionate amount of time sloped up and to the right, with longer-dated bonds sporting higher yields than Treasury bills maturing in mere months. When the yield curve does normalize, Annaly and AGNC should see notable improvements in their respective net interest margin and book value.
The final reason for investors to pounce on these ultra-high-yield income stocks is that Annaly Capital Management and AGNC Investment have geared their respective portfolios to maximize profits and protect their principal. They do this by focusing on agency assets.
An "agency" asset is backed by the federal government in the event of default on the underlying security. Annaly closed out March with 88% of its $73.5 billion investment portfolio in highly liquid agency assets. Meanwhile, all but $1.1 billion of AGNC's $63.3 billion investment portfolio was tied up in various agency securities at the end of the first quarter.
Although having this added protection lowers the yield these mortgage REITs receive on the MBSs they purchase, it allows them to prudently lever their investments to maximize profits. This leverage is what can allow Annaly and AGNC to maintain their respective 13% and 14.8% yields.
Following years of underperformance, Annaly and AGNC appear ready to shine for patient income seekers.
Sean Williams has positions in Annaly Capital Management. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
