The Fed is feeling the love of a higher stock market and its ability to reinflate household wealth at the quickest pace of any other avenue to restore consumer confidence. By holding rates near zero percent until 2015, they essentially force investors out of savings and into the stock market, targeting none other than income-paying stocks, funds and other high-yield liquid assets.
It’s the best of all scenarios for what I recommend and focus on in Cash Machine.
One sector I’m especially bullish on this year is mortgage REITs. Though investors should be aware of the pros and cons of mREITs, when mortgages can be bought for 60 cents on the dollar and the Fed is participating in the open market on the buy side, so should investors. We’ve been seeing some top-end improvement in several areas, with the Fed and the government doing all they can to resuscitate the housing market.
ARMOUR Residential REIT (NYSE:ARR) is a fresh name for most investors who are seeking high-yield income in the REIT arena. It runs a highly leveraged portfolio of mortgages. Unlike the more popular American Capital Agency (NASDAQ:AGNC), the composition of ARR’s portfolio is quite different and thus is better suited for the current market that’s pressuring the spread of borrowing short and investing long. And ARR offers a 16% yield, whereas AGNC’s yield is 13% and might drop in the near future.
I actually had AGNC in my portfolio up until just a month ago, but its latest quarterly figures released in August gave me pause. The interest rate spread that supported AGNC’s dividend yield declined from 2.31% to 1.65% as fixed mortgage yields fell in conjunction with the sharp rally in Treasury bonds. To maintain its quarterly dividend of $1.25 per share, AGNC had to receive $40 million in interest income.
At its current leverage ratio of 7.5:1 against the reduced spread, AGNC is forecast to generate only $33 million going forward, portending a cut in its dividend payout sometime before year’s end. The risk just wasn’t worth the reward for me.
On the other hand, ARR’s current portfolio of $13.3 billion portfolio of agency securities consists of 78.6% fixed-rate agency securities, 100% of which have 20-year final maturities or shorter. The company’s portfolio also consisted of 21.4% adjustable rate mortgages (ARMs) and hybrid ARMs. The ability to ramp up the adjustable percentage of holdings in the event of increasing interest rates appeals to me. That, plus the use of portfolio insurance, is a big plus.
ARMOUR invests not only in fixed-rate mortgages, but also in hybrid adjustable-rate and adjustable-rate residential mortgage-backed securities (RMBS) issued or guaranteed by U.S. government-chartered entities. This is a key point because floating-rate loans don’t get prepaid, so ARR can avoid the kind of situation that AGNC is running into. When rates eventually rise, so will its portfolio interest income.
Another reason to like ARR: The crowds haven’t arrived yet. But when they do, they’ll lift the stock higher, and we’ll already be well-positioned for the ride.
Bryan Perry is editor of Cash Machine, a newsletter focused on dividends and income investing.