For an asset class that is so large and widely talked about by analysts, mREITs have a very simple business model. They borrow short term and use that cash, and cash from stock offerings, to purchase long-term debt. Because of the nature of yield curves, long-term debt has higher interest rates than short-term debt, allowing mREITs to make money on the "spread" between the rates. As long as the mREIT can roll over its short-term debt when it comes time, it can usually make a nice profit that it distributes to its shareholders.
Thinking about the mREIT business model made me wonder how plausible it would be to make a portfolio that shorts securities with low volatility and low dividend yields and use the cash, along with some starting cash, to buy securities that have high volatility and high dividend yields to attempt to replicate the mREIT value proposition. My logic was that low-volatility securities demand lower returns from shareholders and high-volatility securities demand higher returns, so in theory it should work. The end product turned up some pretty interesting results.
Let me start by saying that the portfolio idea I'm about to unravel is very high risk and should only be attempted by those who like to take aggressive positions. The following transactions and holdings that I am about to discuss were executed in an experimental portfolio that did not use real money. I am a conservative investor and I wanted to see how this idea would play out in an experiment before I considered trying to use this investment model for real.
The Initial Portfolio (Sept. 26, 2011)
|Symbol||Asset Class||Action||Cash Value|
|SHY||Treasury Bond ETF||Short||$40,000,003|
|HYV||Corporate Bond ETF||Buy||$1,106,000|
|LQD||Corporate Bond ETF||Buy||$11,268,000|
|HYG||Corporate Bond ETF||Buy||$8,553,000|
|TLT||Treasury Bond ETF||Buy||$8,322,300|
|OHI||Health Care REIT||Buy||$3,045,000|
|CS||Intl. Financial Holdings||Buy||$2,534,000|
1. Raising Capital
Before buying securities, I needed to raise capital. I started with $10 million in cash. I decided to simulate the borrowing of debt through shorting a treasury bond ETF. Since the name of the game with choosing this short is low volatility, I went with iShares Barclays 1-3 Year Treasury Bond Fund (SHY). I shorted $40 million worth of the bond ETF at $84.57, and since then it has made monthly dividend payments between 3.03 cents and 4.88 cents with a generally downward trend. This was the least volatile ETF that I could find. In addition, the ETF contains short-term debt that is rolled over by the fund manager, which strongly coincides with my objective. Its current 52-week range is from $83.67 to $84.75. Since this is such a low-volatility security, I knew I had to make my portfolio as diversified as possible so that a bear market cannot collapse my margins and bankrupt my fund. In October, after a shaky start, I did have to cover about $2 million of my short to free up capital, but I eventually returned to my original position.
2. Buying mREITs
Since mREITs are volatile and have high dividend yields, I figured that they would be a great way to start off the buying spree. In this case, I went with two Agency mREITs: Invesco Mortgage Capital (IVR) and American Capital Agency Corp (AGNC). Both mREITs had dividend yields over 20 percent when I started, but since have lowered their dividends, as expected. Today they yield 17.7 percent and 16.6 percent, respectively, so they still fit the profile of being high volatility and high dividend securities. With my $50 million in capital, I invested just over $7 million in these two mREITs, and since have not bought or sold any mREITs. In a real world application of this model, I would suggest also delving to non-agency mREITS like Annaly (NLY) and looking into lower cap options to add to the portfolio to avoid bankruptcy risk.
3. Bond ETFs
Since my entire short position is on a short-term treasury bond ETF, I decided that adding higher yielding bond ETFs was much needed in order to simulate taking advantage of an interest rate spread. I took long positions in HYV, LQD and HYG, which are all corporate bond ETFs. HYV is a corporate high yield fund from Blackrock. It currently boasts an 8.4% dividend yield, which is pretty high for a corporate bond ETF. LQD is an investment grade corporate bond ETF from iShares. With a dividend yield under 5%, this doesn't necessarily blend in with all of the other high yield securities in this portfolio, but it still has a higher dividend yield than the short and it provides a solid foundation for my assets to prevent the fund from going bankrupt in the event of a market downturn. HYG is the iShares high yield bond corporate bond ETF. I bought in at $85.53 and the ETF offers a monthly dividend usually between 51 cents and 57 cents, which is pretty good. With almost a $21 million initial position in Bond ETFs, this is by far my largest investment of any asset group. Since starting the portfolio, I have only sold about 10% of my LQD shares to make the portfolio more liquid in October. In March, I took a $4 million position in JNK, Barclay's high yield corporate bond ETF, to expand on my corporate bond position. I also added to my holding in HYV. I feel like I can make consistent income from the yield spread between these bond ETFs and SHY due to the rate differences between the underlying assets.
4. More REITs
I decided to diversify a little bit more by buying into REITs backed by physical assets. I bought into CommonWealth REIT (CWH), whose holdings consist of corporate and industrial buildings; Omega Health Case Investors (OHI), which owns medical buildings; and Government Properties Income Trust (GOV), which leases out government buildings. REITs like these are great for portfolios because they allow investors to take a position in an industry or a sector in addition to an investment in real estate. These REITs generally boast yields between 4% and 11%, and I chose these because they tended to be near the top of their industries in dividend yield. Since starting the portfolio, I closed out my OHI holding and took a $3 million position in Medical Properties Trust (MPW), a different Health Care REIT.
So far, there has only been one publicly traded corporation in my portfolio, and that company is Credit Suisse (CS). I chose Credit Suisse because at the height of the financial crisis, the company's annual dividend gave it a great looking yield -- even when considering the expected yield for 2012. In addition, I wanted to keep the faith in my corporate investments by making them volatile. I have gone in and out of my position in Credit Suisse since the start. I try to buy when Europeans doubts are at their peak and sell when the European Debt Crisis is not making headlines. It was one of my most profitable investments and helped me fund some of my newer positions. In a real life application of this portfolio, I believe that some publicly traded companies should be added to the stew. I think high yield blue-chips like AT&T (T), MLPs like NuStar Energy (NS), and energy companies like Duke Energy (DUK) could all do well in creating a spread. These companies have strong cash flow and high payout ratios, so investors generally see a high yield return between 4.5 percent and 7 percent.
The Portfolio Now (April 4, 2012)
|Symbol||Asset Class||Action||Cash Value|
|SHY||Treasury Bond ETF||Short||$39,996,368|
|HYV||Corporate Bond ETF||Long||$3,936,000|
|LQD||Corporate Bond ETF||Long||$10,318,500|
|HYG||Corporate Bond ETF||Long||$8,992,000|
|JNK||Corporate Bond ETF||Long||$4,110,750|
|TLT||Treasury Bond ETF||Long||$7,847,700|
|MPW||Health Case REIT||Long||$2,827,200|
|OHI||Health Care REIT||Long||Closed|
|CS||Intl. Financial Holdings||Long||Closed|
The portfolio has done very well since its inception, with a lot of credit going to the recent bull market. I have made seven monthly cash withdrawals (to simulate dividends) totaling $1.31 million and the total portfolio now is valued at $13,458,481. Since Sept. 26, the portfolio returned over 47.5%, or about 110.7% per annum. The annual "dividend" yield of the portfolio is around 22.46%. None of this return data includes taxes and fees, but it still shows how an investor can make a winning portfolio by trying to exploit interest rate spreads, whether it's high risk over low risk or long term over short term.
The big advantage mREITs have over a portfolio like this is their tax advantage. If they pay out 90% or more of their income, they do not have to pay federal income tax. However, I believe this is a plausible investment model for an aggressive investor, even with taxes included.
The point of this article was to show an income investing strategy from a new viewpoint. I'm still trying to come up with new ideas for where to take this concept and will try to share them from time to time. So far it's worked out and it will be interesting to see if this portfolio can continue to post high returns.