One Generation's Nightmare Makes mREITs A Good Risk

Includes: MORL, MORT, REM
by: Benjamin Cole


Buy mREITS, interest rates dead. Get two-digit yields in a one-digit world.

30-year secular trend is towards ZLB.

Japan never escaped ZLB, Europe headed there. Is the US next?

Interest rates are dead in the water.

That unaccepted reality makes mortgage REITs (mREITs) a very interesting play. The market habitually fears higher interest rates, a scenario that would shrink mREIT profits.

In a nutshell, mREITs borrow short to lend long. Dicey business. But if interest rates stay put -- and rates are unlikely to wander far in any direction -- then investors pick up double-digit mREIT yields in a single-digit world.

The old story: Reward for risk. But in this case, the risk is way overstated.

Reality Vs. Fears

It is known -- but nearly always ignored -- that inflation and interest rates have been in a global secular swoon since the early 1980s, when double-digits were the norm.

Click to enlarge

The chart above shows U.S. rates, but the same story is told in all the developed nations, with domestic variations. Central banks have whipped inflation. Today, there is near-deflation in Europe, and Japan has been deflating for 20 years, until very lately.

The U.S. Fed hawks are beating their drums, Fed Chief Yellen is quitting quantitative easing, and the U.S. inflation rate is around 2 percent.

Forget inflation, forget rising rates. But many can't.

There is a whole generation of economists and investors who chronically believe that higher inflation and interest rates are inevitable. They lived through the 1970s and early 1980s. So did I. It was a scarifying experience. A fear of "accelerating" inflation was instilled, and has since ossified into place. My nightmares are of inflation that "gallops" -- it never walks. But nightmares are not rational. Investors should be.

The mREIT Opportunity

Look at the yields in mREIT land: Annaly Capital Management (NYSE:NLY) offering a 10.30 percent dividend. CYS Investments Inc. (NYSE:CYS) 14.32 percent, or American Capital Agency (NASDAQ:AGNC) at 11.34 percent. Those are some of the big names, indicative of the sector. They are well-followed stocks; probably no unpleasant surprises lurking, though all are vulnerable if rates go up.

If you like diversifying, consider some mREIT ETFs, such as iShares Mortgage Real Estate Capped ETF (NYSEARCA:REM) or the iShares FTSE NAREIT Mortgage REITs Index Fund, with the awful ticker symbol MORT (NYSEARCA:MORT) (a moniker that roughly translates into "dead," for you Latin fans).

If you are the type who has the stomach for high-stakes poker, then try ETRACS Monthly Pay 2x Leveraged Mortgage REIT (NYSEARCA:MORL). If rates rise, you will not do well, but if they don't you will collect handsomely. Fellow Seeking Alpha writer Lance Brofman recently noted MORL is offering a 22.9 percent yield. That does get one's attention, risks or no.

If the markets come to believe interest rates and inflation are in fact dead, you will get some capital appreciation on all the mREIT plays as well, ceteris paribus, of course.

I won't pretend special insights on the above mREITs or ETFs, or any others. There is gobs of market information out there on these stocks and funds, and I tend to believe in efficient market theory (even though this post suggests EMT doesn't work 100 percent of the time -- but then how would pundits eat if we owned up to EMT?).

Trend Is Your Friend And More

Not only is the 30-year trend your friend in interest and inflation rates, but consultancy Bain & Co. says capital will remain "superabundant" in the years ahead, in a report entitled, A World Awash in Money: Capital Trends Through 2020. The International Monetary Fund more or less repeated the "low interest rates are here to stay" theme in its World Economic Outlook 2014. The IMF cited the obverse side of the coin: weak demand for capital in the developing world. See here and there.

Gee, heavy supply of, and weak demand for, capital. You might think, "lower rates." I think so, too. Maybe the market will too, soon.

Normally, free marketeers (and I am one) would insist low yields would depress savings, and self-correct. But globally, there are sovereign wealth funds, pension funds obligated to build assets by law, and insurance companies that must have enough capital to meet claims. Then, there are nations such as China and Japan with traditionally high or even somewhat compelled savings rates. Also, there has been an international explosion of high-income households, able to save for the first time in history. Even think Russian oligarchs, who accumulate piles of lucre regardless of interest rates. So capital piles up, impervious to lower interest rates.

A lot of capital is looking for a home. Remember that always.

The Real Risk

The real risk is such a capital-soggy world is not higher interest rates but another recession, caused by central bank tightness and poor national government, macroeconomically speaking. Right now another recession is a scary thought, for a lot of reasons.

But remember, even if another recession comes, not every downturn is the 2008 bust-o-rama. Interest rates in the next recession will stay low, property values will sag, but probably not plunge into the financial Mariana trench again. There is a such a thing as a garden-variety recession.

So, the Fed will keep rates at zero, maybe try some quantitative easing again (after hemming and hawing), and another glacial recovery will ensue. But likely you'll collect handsome mREIT dividends the whole way through.

The simple story: The guys in the 50s and 60s age brackets were bruned hard by life in the 1970s and 1980s to expect higher inflation and interest rates. They are the power generation now, the guys running money.

They are my peers. I understand how they feel. But they are probably wrong.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.