Steepening Yield Curve is Bullish for Mortgage REITs

Bryan Perry

A former Wall Street financial advisor with three decades' experience, Bryan Perry focuses his efforts on high-yield income investing and quick-hitting options plays.

In just the past month, the bond market’s yield curve has righted itself in a big way.

As the inverted yield curve had compressed margins to nothing for those entities that borrow short and lend or invest long, profit margins evaporated. In the span of two months, the yield curve has steepened, and spreads have dramatically improved.

At present, real estate investment trusts (REITs) that borrow heavily with short-term interest rates of 1%-2% and purchase mortgage bonds yielding 4%-6% are able to capture a wide spread of 3%-5%. These are mortgage REITs and are enjoying times that, given the latest round of data, appear to remain an opportunistic buy for many months to come.

Mortgage REITs usually own no actual property. Instead, they merely function as a type of closed-end, private equity fund. Specifically, mortgage REITs raise both debt (via lower rate, short-term loans) and equity (via new share issuances) capital to buy longer-term and higher interest rate real estate debt and related securities. The difference, or spread, between the cost of borrowing and lending is how they earn their profits. It is also what ultimately supports their respective dividend.

In other words, mortgage REITs function as a less regulated, riskier kind of bank, as they aggregate cheap capital and then indirectly lend it out at higher interest rates by purchasing mortgage-backed securities. Mortgage REITs that leverage their portfolios 5:1 or 6:1 can generate up to 15% in interest revenue. Structured as REITs, they are required to pay out 90% of that revenue stream to shareholders, after expenses and fees.

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This is what makes mortgage REITs so attractive and why they have piqued my interest. I believe that the conditions for investing in these specific bonds on a leveraged basis with professional management makes for both a strong investment theme and one that I am going to be recommending this month as I aim to continue to put capital where reliable high-yield dividends and upside potential coexist.

Following the dismal August-September period for the market as talk of a recession dominated the narrative, investor sentiment took a profound turn for the better as the U.S. economy picked up speed, progress occurred on the trade talks with China, inflation stayed low and the Fed kept its proactive policy. What this means is that the Fed will keep short-term rates low to maintain cheap money for banks and lending institutions, while yields on longer-term Treasury securities will rise in reaction to a stronger economy in 2020.

Because of the unique setting that exists for mortgage REITs and the fact that it could persist for the next year, I currently view this sector as a very attractive place to purchasing shares for my Cash Machine model portfolio. Most mortgage REIT stocks are trading near their 52-week lows and sport dividend yields in the 8%-12% range. These facts make them a good risk/reward proposition if shares in the right companies are purchased. Top-tier management is essential in limiting risk in this sector, so stock selection is hugely important.

Even in a crazy market like the present, there are always a few sweet spots that don’t necessary get the headlines, but they do attract the big money. To get in on my next high-yield recommendation and the rest of the Cash Machine portfolio, click here to sign up today and give yourself a big pay raise for 2020.

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