For many investors, 2013 has been a good year.

On May 7, the Dow Jones industrial average broke 15,000 for the first time ever. Since Jan. 1, the S&P 500 is up more than 15%. Microsoft, a company whose share price has been relatively flat for years, is up more than 30%.

But there is one market sector that never got invited to the party. In fact, many of the companies that make up this unique market niche have seen their share prices plummet over the past three months, falling by as much as 20%.

Share prices have fallen so far that many of these high-yielders are now trading below book value. In other words, investors are now able to snap up shares of companies yielding up to 19% for less than the company would be worth if it were to liquidate its assets and pay back its liabilities. 

If you haven’t guessed, I’m talking about mortgage REITs (real estate investment trusts). 

This sector has taken it on the chin since the Federal Reserve signaled that it may cut back on its quantitative easing program earlier than expected. Though nothing definitive has been outlined, the market has been in panic mode. Several of these companies have reached what I consider to be oversold territory, and the time is ripe for investors to snatch up these high-yielding shares below book value.

Before you decide whether mortgage REITs are the right investment for you, it’s important to understand how mortgage REITs make money.

To begin with, unlike some REITs, mortgage REITs do not own physical property. Instead, they invest in home or commercial mortgages that have been bundled together into mortgage-backed securities.

These loans are backed by investment firms and government-backed agencies such as Freddie Mac and Fannie Mae. They generally carry a AA+ rating and are at low risk of default.

Mortgage REITs make money by earning a higher rate of return on the long-term yield of mortgage bonds than the rate they pay on their loans to buy these bonds. This yield curve is what allows mortgage REITs to turn a profit.

Like all REITs, mortgage REITs are required by law to pay out 90% of their earnings as dividends. This is why dividend yields in this sector tend to be high.

The only catch is that because they are unable to squirrel away money to purchase new assets, mortgage REITs often raise capital by issuing new shares, which dilutes the value of shares held by existing shareholders. For example, between 2011 and 2012, American Capital Agency (NYSE: AGNC) doubled its outstanding share count from 153 million shares to 304 million. 

While mortgage REITs have seen a lot of volatility so far this year, I think that most of investors’ fears for the future have already been baked into current prices.

Here are my three favorites, from the safest to the most speculative:

Market Vectors Mortgage REIT Fund (NYSE: MORT)
Instead of putting all of your eggs in one basket, the safest way to play this sector is to invest in a bundle of mortgage REITs. The Market Vectors Mortgage REIT Fund boasts a yield of 11.6% and a modest expense ratio of 0.4%, leaving investors with a solid 11% yield. This fund tracks 25 mortgage REITs, with Annaly Capital Management (NYSE: NLY) and American Capital Agency (NYSE: AGNC) making up 31% of the fund’s holdings.

Annaly Capital Management (NYSE: NLY)
Because of its size and long history relative to its peers, Annaly has earned the right to be considered a less risky investment than many newer mortgage REITs. The company is the largest public REIT financer of U.S. residential mortgages, with a market cap of nearly $13 billion. The company has been publicly traded since 1997, and in that time it has shown it can weather a wide variety of market conditions.

It has also paid a dividend every quarter since its inception, and over the past five years the dividend hasn’t dipped below 13% on an annual basis.

Today the company is trading below book value. At less than $14, share prices have not been this cheap since early 2009. And in early 2009, share prices had just been battered by the financial crisis of 2008. 

Annaly’s projected yield is 13%, down slightly from last year’s 14% yield. Still, some company insiders have seen the recent low valuations as a buying opportunity. In November, company President Kevin Keyes purchased 100,000 shares of Annaly stock at $13.90 a share. Insiders can be notoriously bad at timing the market, but insider investing is a factor I find encouraging. At today’s prices, investors now have the opportunity to buy shares for less than the company’s president paid not too long ago.

American Capital Agency (NYSE: AGNC)
AGNC is the highest-yielding stock in this group, boasting a current and projected yield of more than 19%. But it is also the most risky.

On the surface, AGNC’s first-quarter results were pretty dismal. The company reported a comprehensive loss per common share of $1.57. This follows a gain of $2.44 per share in the previous quarter.

So the big question investors should be asking is: Is the 19% dividend sustainable?

In short, the answer is no.

At its current rate of distributions based on a percentage of estimated taxable income, the company is paying out 282%, (or almost three times) what it’s bringing in. AGNC has attempted to mend this capital shortfall by issuing 115 million more shares of stock during the most recent quarter.

This model is not sustainable. And I expect a dividend cut could very well be in the cards sometime in the near future.

But despite the recent slump, the company is still profitable overall. Free cash flow for the first quarter was $518 million, up from the $472 million reported in last year’s fourth quarter. While this number can be seen as the result of the new share issuance rather than any improved performance on the part of the company, at least AGNC has managed to stanch the bleeding for the time being.

In a recent High-Yield Investing update, Carla Pasternak made a strong argument for holding on to her position in AGNC based on the company’s operating performance:

A closer look shows that [AGNC’s] operating performance during the quarter was actually strong. Profit margins, or the difference between what the company earned on its investments and what the company paid to finance these investments, were 1.52%. That’s down slightly from 1.63% in the prior fourth quarter of 2012, but up from 1.42% in the third quarter. As well, the company had an estimated $430 million, or $1.08 per share, of estimated undistributed taxable income that could be used to supplement the dividend. 

In spite of the recent drop in share price, and thanks to the outsize dividend, investors who took Carla’s advice and purchased the stock a year ago are still up over 14% on the recommendation. Such is the power of a high dividend yield. 

Still, more cautious investors may want to wait until August and the release of AGNC’s second-quarter earnings report before making a decision as to whether AGNC is appropriate for their portfolio.

Risks to Consider: Mortgage REITs are subject to changes in interest rates and as such can be volatile and risky investments. Always position your portfolio size accordingly. Also, because the income generated from these investments is taxable, they are best held in a tax-deferred account.

Action to Take –> I like the Market Vectors Mortgage REIT Fund as the safest way to play the sector, but investors with greater risk tolerances may find Annaly Capital Management and American Capital Agency more appealing.

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