Several Reasons Investors Should Consider Mortgage REITs As An Alternative To Junk Bonds

Includes: AGNC, ARR, CIM, NLY
by: Matt Schilling

In my last article, which discussed the evaporating yields of the junk bond sector, I pointed out two of the reasons why I think PIMCO's Bill Gross was wrong about the sectors' stability as a long-term investment option. In the days following the article's publication, Jim Kochan of Wells Fargo Advantage Funds made a very strong case for junk bonds and bond-based portfolios.

According to an article featured on, he points out that, "It is natural for investors to become wary of a market that has rallied as much as the high yields have over the past three years. While it might be prudent to underweight the most risky sectors of the market after such a strong rally, it is probably too early to abandon the high-yield market entirely." I agree with the fact that investors shouldn't completely abandon the high-yield market; however they should begin to consider several alternatives to the junk bond sector.

One of the best alternatives for yield-seeking investors to consider, in my opinion would be the Mortgage REITs. Why? Although the Mortgage REITs rely heavily on the behavior of certain types of bonds, they provide the aggressive high-yield investor with rates that have been traditionally higher than most junk bonds. Mortgage REITs such as Annaly Capital (NYSE:NLY), American Capital Agency (NASDAQ:AGNC), Chimera Investment (NYSE:CIM) and Armour Residential (NYSE:ARR) all benefit from the rising yield curve, which can increase profit margins when it widens the spread between the interest cost of borrowing and the interest income from the physical mortgage portfolios each company currently holds.

Should investors be concerned about many of the recent declines in dividend distributions over the last 12-24 months? I think they should, and even though the declines from such companies as Annaly and Chimera have made them slightly less attractive than they once were, both companies are still yielding at least 12.50%. According to Douglas Harter of Credit Suisse, "The sector is still paying out low double-digit dividend yields, and while we are past peak returns, I do think that level of low double-digit returns should be sustainable for the next two-plus years."

Are there any negative catalysts investors should consider before establishing a position in the Mortgage REIT sector as an alternative to the high-yielding junk bond sector? I wouldn't necessarily consider it a negative catalyst as much as I would consider it a wild card, but the Federal Reserve is certainly a lingering factor. We all know that the Federal Reserve announced, "Its highly-anticipated quantitative easing, or its so-called QE3 would begin on September 13th, and includes the purchasing of additional agency mortgage-backed securities at a pace of $40 billion per month along with the maintenance of the federal funds rate at a level of 0.00% to 0.25% at least through mid-2015". If for any reason the Fed abandons its course and raises rates above that key 0.25% level, we could see a significant change in the yield curve and the profit margins of the above mentioned four Mortgage REITs diminish significantly.

Disclosure: I am long CIM, NLY, AGNC, ARR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.