Mortgage REITs Offer Value to Yield-Hungry Investors

Jul. 6.11 | About: Anworth Mortgage (ANH)

By Carla Pasternak

Yield-starved investors are wondering where they can capture high yields when a savings account pays 0.5%. A certificate of deposit (CD)? A one-year CD pays 1.2%, according to BankRate.com. That doesn't even keep up with inflation. We've already seen bond prices surge as income investors scramble to find anything paying a remotely high yield. And it doesn't look like things are going to change anytime soon.

Recent soft U.S. economic data and what Federal Reserve chair Ben Bernanke calls a "frustratingly slow" economic recovery have lessened the chances for rate hikes. The consensus among futures traders is that the Fed won't raise rates until mid-2012. Even then, the July 2012 federal-funds futures contract is pricing in just a 30% chance the Fed will hike the funds rate to a still-low 0.5%.

Oddly enough, this low-rate environment is great for a group of securities I've been tracking. This asset class routinely provides yields of 10% -- even 12% or more. And no, I'm not talking about distressed securities that give you gargantuan yields because the share price has plummeted. On the contrary, some of these securities enjoy stable prices and even recent price gains.

So where can you find them? They're called mortgage real estate investment trusts (mREITs). Unlike their better-known cousins that own real estate properties such as shopping centers or medical office buildings, mortgage REITs own no physical property. Rather, they invest in residential mortgages that have been bundled together into securities called mortgage-backed securities (MBS).

I think the best investments are those with portfolios filled with so-called "agency" loans -- securities guaranteed by Fannie Mae and Freddie Mac -- which are in turn backed by Uncle Sam. This backing lessens your risk.

How can these companies offer such supersized yields? Mortgage REITs profit from the difference, or spread, between interest rates earned on the mortgage loans in their portfolio and their short-term borrowing rates.

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One M-REIT I found -- Anworth Mortgage (NYSE:ANH) -- earned net interest of 3.11% on its mortgage assets during the first quarter of this year. But it paid an average 1.39% to fund these assets. The difference of 1.72% is basically its profit.

These 1% to 2% returns don't sound like much, but looked at in another way, Anworth's $57 million of interest income for only $22 million in interest expense leaves a $35 million gain the first three months of this year alone. These returns shrink or expand as mortgage rates or borrowing costs rise or fall.

Right now, mortgage rates are near historic lows, but mREITs are benefiting from record-low short-term lending rates. They can borrow for next to nothing. This won't last forever, but as I mentioned earlier, I think rates will stay plenty low for some time. This means the high yields we're seeing with this special breed of REITs should be secure for some time.

Certainly, risks are inherent in the mREIT model, as with anything yielding double-digits. Some are built-in, such as future interest rate increases or consumer prepayment of mortgages. Others, such as congressional legislation affecting Fannie Mae and Freddie Mac, are more situational. But for a yield-hungry investor, securities such as these -- with a double-digit yield and a business model to sustain these yields -- may be worth the risk.

Disclosure: Neither Carla Pasternak nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

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