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Registered investment advisor, bonds, closed-end funds, ETF investing
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First, the giddy optimism:

Reuters reports that a survey of Wall Street strategists believes the S&P 500 will rise 6% in 2012. Another survey of 10 investment firms showed an anticipated gain of 10% by year-end. And forecasters at Citigroup and Ned Davis Research are suggesting the possibility of a new bull market within a year or two.

That's great. We hope all of this happens. But if it does, it will have overcome headwinds that aren't abating much, including:

  • U.S. economic growth expectations of just 2.7%, according to a survey of economists by The Wall Street Journal.
  • A stubbornly weak job market, notwithstanding recent, but ever so slight, improvement.
  • A languishing housing market, dragged down by obstinate political resistance to processing foreclosures that would readily locate price equilibrium.
  • Limited U.S. exports caused by slowing global growth.

So what is it going to be? Can the stock market overcome these economic obstacles? Might there even be an election-year rally?

Heck, maybe we're at the lowest tier on a wall of worry and this will prove to be the best time in a generation to go all in. But that's a big maybe, and we aren't at all convinced that a raging secular bull market is on the horizon. Indeed, for all we know the stock market could be lower by 10% by the end of the year.

And that's the point. We just don't know, and we don't think anyone else knows either. After all, when the likes of Bruce Berkowitz, manager of the once-exalted Fairholme Fund, and "Bond King" Bill Gross, are now found licking some very deep wounds, we aren't inclined to blindly trust anyone's predictions these days.

Still, we'd like to make some money, and we think that we can with some careful management. That's the idea behind our "Stable High Yield" model at Covestor.com.

The portfolio is significantly invested in high-yielding mortgage real estate investment trusts. These vehicles arbitrage short-term borrowing opportunities at today's historically low interest rates against higher-yielding mortgage-backed securities. This allows most of these mREITs to throw off yields in the teens. We prefer "agency mREITS", because most of their holdings are guaranteed by government agencies like Fannie Mae and Freddie Mac. And because each has its own management strategy, we are careful to diversify among them. Included in our model are American Capital Agency Corp. (NASDAQ:AGNC), Anworth Mortage Asset Corp.(NYSE:ANH), Capstead Mortgage Corp. (NYSE:CMO), CYS Investments, Inc. (NYSE:CYS), Hatteras Financial Corp. (NYSE:HTS), and Annaly Capital Management, Inc. (NYSE:NLY).

That accounts for the "high yield" in our portfolio's name. And we work to make the model "stable" by offsetting the high-yield component with short-term fixed-income securities, such as SPDR Barclays Capital Short Term ETF (NYSEARCA:SCPB) and Vanguard Short-Term Corporate Bond ETF (NASDAQ:VCSH). That lowers our risk, and the importance of that cannot be overemphasized in today's investing marketplace. We want to make money, but really don't want to lose money.

Our risks include mortgage refinancings at today's low rates and any prospective rise in interest rates. But although refinancings have caused mREITS to reduce their dividends somewhat in recent quarters, their yields are still generally in the teens or higher. And refinancings have actually slowed by 28% since August, according to the Mortgage Bankers Association.

The interest-rate risk? The Fed's current low-rate policy may now extend far into 2014, according to recent reports. That's good for mREITs.

Some mREIT stock prices have not quite kept pace with the overall market rise since the early October lows, but their high yields serve to compensate.

Owning mREITs will always require nimble management by the investor, and that's our charge as a portfolio manager. We'll have to be on the lookout for any adverse developments and then deftly reconstitute the portfolio accordingly.

Disclosure: I am long AGNC, ANH, CMO, CYS, HTS, NLY, SCPB, VCSH.

Source: Mitigating mREIT Risks With Short-Term Bonds