Lessons Learned On RMBS Portfolio: Income Strategy Or 401K Peril?

Includes: AGNC, CIM, CYS, IVR, TWO
by: James Shell

I wrote this article last August in which I suggested that Residential Mortgage Backed Securities (RMBS) might be a good method to inoculate one's 401K from the effect of Bernanke's zero interest rate policy, which as we all know is a massive transfer of wealth from the holders of capital to the borrowers.

In that article, I suggested four RMBS funds: American Capital Agency (NASDAQ:AGNC), Chimera Investment Corporation (NYSE:CIM), Cypress Sharpridge Investments (NYSE:CYS), Invesco Mortgage Capital (NYSE:IVR) and Two Harbors Investment Corp. (NYSE:TWO), all of which were paying exceptional dividends. I actually made an equally weighted investment in all five in the late March time frame. Here is the outcome of my investment thus far:

The Top:

Cypress Sharpridge Investments which has gone from $12.55 to $12.98 since March, and the dividend is $0.55 per share. Four analysts have initiated coverage with a "buy" recommendation since June. 28.22% return on equity for the trailing 12 months. Earnings are projected at $1.77 in 2011 and $2.10 in 2012.

The Middle:

American Capital Agency and Two Harbors Investment Corp. have lost 5% and 19% of their market values respectively since Spring. AGNC's third quarter revenues went from $62M to $262M year on year, the company focuses on government-backed securities. Two Harbors' portfolio is about 80% Agency-backed securities, and has gone from a portfolio value of $1.3B to $6.4B in the last year.

The Bottom:

Chimera and Invesco, which have lost an average of 37% of their nominal market value since spring. Chimera has 80% of its portfolio in non-agency backed securities, and had net interest income of $177M in the last quarter. But Chimera has been writing down a lot of "other than temporary impairment losses" for the last two quarters that have been keeping this money from reaching the bottom line. Invesco Mortgage Capital annoyingly issued an additional 20 million shares of stock in August, diluting the shares of the previous stockholders. Half of its portfolio consists of 30-year fixed rate mortgages, with an average rate of a little more than 5%. Both of these funds have been downgraded in November.

All of the quarterly reports of these companies say basically the same thing: All are hurt by fluctuations in long term interest rates and other volatility in the financial markets, all are either directly or indirectly affected by the policies of the Fed and other government agencies, which interject an element of uncertainty, and all are participating in various credit swaps and other activities to try to keep the fluctuations to a minimum and distribute 90% of their income to shareholders so that they can keep their status as REIT's.

So, things could keep going like this for awhile.

However, here is the trade off: Since I made my transaction in April, I have collected three nice rounds of dividends, which, on my original cash investment, has paid 12% cash on cash return. The unrealized gain or loss on my account balance notwithstanding, I cannot be too sad, particularly in light of the artificially depressed interest rates available on CD's and other investments since that time, not the least of which is the S&P500, which has gone down by approximately 10% since then.

So here are the lessons learned:

As long as I concentrate on the nice cash balance that I have because of the dividend payments, and do not worry about the volatility, I am happy, and would consider my investment to be successful. However, some people, who dwell on the account balance may not see it this way, and prefer not to make this type of investment.

Events beyond our control can affect the nominal value of these stocks a lot. For example: Stock distributions, changes in interest rate or tax policy, events that are global in nature, write offs and other events that may cause the numbers to look bad in a given quarter. However, this is still a good business. These companies are borrowing money at basically zero interest and loaning it out at 5%, the profit margin on this business is on the order of 90%, and although these companies may go through a period like the last six months, where long term interest rates decline and they have to shift their porfolios, this is still a fundamentally nice business to be in.

I am thankful that I diversified, buying a little portfolio of five, which spread out my risk. There is no assurance that the best company in this business will not have some kind of adverse event and turn into the worst a year from now, or vice versa for the worst, so maybe I will not reinvest my dividend in the same group. However, all of them have prospects and I am not ready to walk away yet from even the bottom group without letting these run a little longer.

The world is chaotic, there are no guarantees on anything. However, if you can make 12% return on cash on an investment, you have to shrug off some of the price fluctuations and be thankful.

Disclosure: I am long AGNC, IVR, CIM, TWO, CYS.