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Fed’s Promise Means Boom Time for MREITs

Low interest rates mean good things for profits

   

When Fed chief Ben Bernanke promised the markets that interest rates would stay really, really low through 2014, he handed a gift to investors of all stripes. The biggest winners are anyone invested in companies that borrow money and then use it to invest in higher-yielding instruments. This is known as an arbitrage play, where the company profits on the interest rate spread between the investment and the rate at which it borrows money.

One type of investment that plays the arbitrage game very successfully are MREITs, which invest in securities that are backed by mortgages. Like any mortgage, however, you want to make sure those mortgages are safe investments themselves. The safest are agency MREITs, which hold mortgages issued or backed by Fannie Mae and Freddie Mac. These quasi-government agencies still are in business and still guarantee millions of home mortgages. That guarantee means default risk on this type of mortgage is essentially nonexistent, and because of that lower risk, you see lower yields.

The great thing about MREITs is they have to pay out 90% of their earnings to investors, so they make terrific fixed-income plays. More to the point, however, because the Fed has promised to keep rates so low for at least the next two years, the big interest rate risk associated with these investments has been tamped down significantly. If the Fed raised rates, then MREITs would have to pay more to borrow that money, so their profits would get squeezed. And even a little bump in rates is bad news, because most agency spreads are only 1.8%-2.5%.

Annaly Capital Management (NYSE:NLY) probably is the best-known MREIT. It’s also the largest. You cannot look to the company’s earnings statement, however, to really judge how it is performing or how safe its dividend is. The company is constantly booking extraordinary gains or losses on interest rate swaps or for-sale securities. Instead, you must peek at its cash flow statement. In this case, cash flow from operations reaches into the billions for the trailing 12-month period, more than enough to pay its 13.5% yield. Its spread has been on a bit of a roller coaster, but the Fed announcement should make this an all-clear investment for some time.

Chimera Investment (NYSE:CIM) is a bit more intriguing. Chimera actually owns both agency-backed mortgages and non-agency-backed mortgages, so there is a bit more risk here. However, Chimera is a subsidiary of Annaly and its portfolio is managed by one of Annaly’s divisions. Chimera has less leverage than Annaly, reducing the risk somewhat. Spreads are wider here, ranging from 4.7% to 6.1%. The risk of non-agency-backed mortgages is somewhat factored into the stock price, as the portfolio trades at around 93% of book value vs. 104% for Annaly. You also get a 14.5% yield.

Back on the safer side, Hatteras Financial Group (NYSE:HTS) also trades right around book, at about 102% of book value. It’s leveraged at about 6.7x vs. Annaly’s more modest 5.5x and pays 13.7%.

As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc., which brokers secure high-yield investments to the general public and private equity. You can read his stock market commentary at SeekingAlpha.com. He also has written two books and blogs about public policy, journalistic integrity, popular culture and world affairs.


Article printed from InvestorPlace Media, http://investorplace.com/2012/02/fed-low-interest-rates-mreit-nly-cim-hts/.

©2014 InvestorPlace Media, LLC

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