Profit with the Fed

03/22/2013 8:30 am EST

Focus: INCOME

Neil George

Editor-in-Chief, Income Publication and Products, Agora Financial

As the bond markets finally face a reversal, Neil George outlines a play that should provide a sizable total return as long as the Federal Reserve keeps easing.

Neil, talk to us about the Fed. They always say "don’t fight the Fed," and the Fed is doing a lot. What are the implications for the investment markets?

I think the key thing is that so many people have been complaining about the Federal Reserve and about how they have been stepping into the marketplace and bolstering their balance sheet to an undetermined vast amount of cash, and potentially manipulating some of the interest rate environment in the US, which has been depressing some of the savings rates and deposit rates for a lot of households.

I have a different sort of a twist to look at it. Rather than trying to complain about or fight the Fed, invest with the Fed. In other words, by following along with what they are doing, you can effectively garner some better yields, as well as have some price protection on underlying bond assets.

And how do we do that?

Charles, I think the key thing to look at in particular has been some of the ongoing bond-buying efforts that the Fed has been doing. The Fed has been buying $40 to $45 billion monthly in Treasury market purchases in order to keep longer-term yields from accelerating to higher rates.

They have also—and this is more important—they have also been participating much more so over the past year and into this year in buying again some $40 to $45 billion each month of mortgages and mortgage pools. Therefore, this is creating, in a marketplace that is really not seeing much origination of mortgages...

It’s a supply-demand imbalance.

Exactly, and therefore we are starting to see prices rise in the mortgages.

In addition, there has been a real improvement in the default rate in a lot of the mortgage pools. In addition, we are also seeing that many of the pools that are out there now are providing some very good yields.

Have you got some names to follow this fame?

I think the key thing you want to look at is some of the companies that are easy to invest in that already own some of these mortgage pools, rather than having you do it directly.

You have some real estate investment trusts that effectively all they do, rather than buying property, they are buying the mortgage pools and running it. There are two. One is MFA Financial (MFA) and the other one is run by Invesco Mortgage (IVR).

What are the yields today on those two?

We are looking at about 10% to 12% on a monthly basis.

Any of that principal repayment?

Well, most of it is going to be paid as ordinary income, and because they are pass-through as a REIT and they are not paying corporate taxes on this, you also will get some appreciation allowances, which also shelters some of your own current income.

So the underlying asset in a mortgage pool is probably appreciating if we are getting the real estate recovery?

Correct, so you are getting some capital appreciation, which will also be part of your distribution eventually.

But probably not right now, so it could be 10% or more if your scenario works out.

And that is actually what has been happening.

Roughly what portion of that 10%-plus is capital return that is coming back?

The vast majority is all just current income right now. With the gain part, which is being built into the valuation of these, we are actually looking for an annual return right now of probably about 16% to 17%.

OK, and finally what is your expectation of interest rates? The Fed has been keeping interest rates very low; it keeps telling us that we are going to keep interest rates low for a long period of time...so what is your expectation for Fed policy over the next few years for interest rates?

I think we are going to see some changes, obviously. We are already seeing them in the Treasury market.

Changes? How much change?

Well, we have already seen about a 60-basis-point bump in ten-year yield, and a lot of people are worried about the Treasury market ready to see some further losses as yields go up.

I look at this being a very positive thing, because what happens is people are getting out of Treasuries and they are going into other markets, such as the mortgage market, where there are better returns happening. Also, other markets in corporate and emerging-market bonds are all going to be beneficiaries if people sell Treasuries and start to look at better opportunities.

So you expect interest rates to stay low. How much would interest rates have to rise for you to start to want to get out of these mortgage pools? 3%? 4%?

I think we are looking at from a Treasury standpoint. Even seeing Treasury yields backing up maybe another 100 or 200 basis points, 1% to 2%, you are still going to be basically be very, very positive for the mortgage market. So we have a long positive for what is going to be happening in other parts of the bond market.

So this could be a ten-year play?

Sell Treasuries and you want to be owning and buying the rest of the perceived higher risk part of the bond market.

Related Reading:

A Changing Trend in Tech

5 More Reasons We Favor Bond Funds

A Global Hunt for Yield

Related Articles on INCOME