Two years ago I was making the major switch from an asset base primarily in equity/commodity/real estate assets to a base of income/commodity assets. The income part was to fund my current retirement budget. The commodity part was due to my belief that we had at least another decade of increasing price inflation and currency declines.
The first part of the switch was to get rid of almost all real estate, whether securitized as REITS or actual owned residential and commercial property. The latter was part of old family holdings it was time to sell for a number of reasons, and I was eager to do so before the economy slowed, as the FED was working on a cool off in 2005 and 2006. It took fifteen months from early 2006 into 2007 to unload the properties and a vacation home for all cash without retained notes. It took about five seconds to unload the REITS.
Income in the accounts then came from Vanguard Wellesley Income Fund (VFINX/VWIAX), Loomis Sayles Bond Fund (LSBDX), and increasingly from US and Canadian oil and gas trusts and partnerships up to about 15% of total. This appeared to be an unbeatable program and perhaps one for the very long term. But it was not to be. Although I anticipated a slow down and further inflation, I did not anticipate a world wide crash following a quick inflationary bubble in 2007 and early 2008. Nor did I appreciate how tightly bound the corporate bonds in VWIAX and LSBDX were to their corporate equity fortunes. As both of those funds began to deviate from very long term behaviors in early 2007, I began cutting them back and adding to money market funds which were then paying close to 5%. I didn't entirely get out of LSBDX early enough to avoid a 6% loss by June 2008, but as the losses later got to be over 30% annualized I felt much better.
I really expected the inflation bubble to subside somewhat from later 2006 into early 2008 as the FED tightened, but it did not. After gold hit its high in March 2008 I began exiting most of the commodity plays except for starting a position in the long/short Rydex Fund RYMFX run according to "Trader Vic" Sperandeo's futures strategy in physical, financial (notes, bonds) and currency futures. I sold about one half of my holdings in the oil and gas trusts. Physical gold wasn't sold then or now.
As money market rates began to topple and the whole world fell apart last year I switched a good bit of funds into the Vanguard short term municipal bond fund (VWSUX/VWSTX) for taxable accounts and into the Vanguard short term Federal Income fund (VSGBX/VSGDX) for tax-deferred funds. Short term Federal income means notes and bills of Treasury and GNMA, both guaranteed, and Fannie Mae and Freddie Mac, not guaranteed still but close to guaranteed in their government conservatorships. VSGDX's distribution yield was about 4.5% in much of 2008 and is about 3.5% now. It seemed about the safest play around as the storm raged. VWSUX was paying about 3.25% tax free then and about 2.5% now. Both funds were supplemented with small parcels of longer maturity/duration taxable (TIPS) or state tax-free bonds in the appripriate accounts.
Beginning in October 2008 around the time of the general crash I started buying back small pieces of the oil and gas trusts on sharp declines as I have previously explained. At the first of this year I switched mostly out of VSGDX and into VFIJX which is a pure GNMA fund with a fairly short duration but paying about 5%. VFIJX has a little more interest rate risk with a maturity/duration close to two years, but is still short term and with an AAA rating and larger payouts.
The oil and gas trusts are coming back, but of course their current total payouts are far smaller than last year since they depend directly upon current oil and gas prices received. So I have been looking at some ways to increase income portfolio yields. I have spent many hours getting up to speed on mortgage REITS (mREITS), as one possible alternative or supplement. As with real property REITS, mREITS pay no US or state income taxes as long as they follow very strict SEC and IRS rules. Thus they are taxed only at the recipient level and for tax-deferred accounts not until the money is withdrawn.
Basically the goal of a mREIT is to do what banks used to do, namely borrow money at lower short term rates to buy longer term higher yield mortgages. Since most mREITS buy only mortgages guaranteed by Freddie Mac, Fannie Mae, and or Ginnie Mae, their credit risk is low. This enables them to save on their borrowing costs. Of course they have a number of other risks. Primary among the other risks is yield curve risk. If short term rates rise more than long term rates the spread on which they make their money shrinks. So a steeper curve rising from low at the short end to higher at the long end is more favorable. Look at this dynamic chart of the yield curve from January 2001 to present to review the history of this highly variable factor in this century. There are other risks related to mortgage pre-payment dynamics (re-fi's) and the exact types and durations of mortgages (fixed, ARM, hybrids with resets, and caps and floors etc.). Some of this can be well or poorly hedged, or the risk can be accepted on a watchful basis.
Then note this chart of Annaly Capital Management, a veteran mREIT with prices and total annual dividends for each year. Clearly the yield curve you've just seen forecasts or follows closely the price of and mREIT.
I said mREITS operate somewhat like traditional banks, and that includes leveraging their investment. Banks can leverage their deposits and other defined capital at many times the dollar value. mREITS pay more for their borrowed funds than banks typically do. so they tend not to leverage as greatly. I've read prospectuses and other publications for a number of mREITS and find that they tend to leverage from about five to ten times borrowed funds depending upon the market and various risk measures. So if a mREIT has $1 billion in capital from stock and/or bond issuance, they may borrow from $5-10 billion. They do this in phases. So instead of just buying the mortgages like, say, Vanguard GNMA Fund (VFIJX) does, they buy mortgages with their own original capital plus borrowed capital to increase the leverage.
Vanguard may make 5% or $50,000,000 on its hypothetical $1 billion portfolio. But an mREIT will make that much on its first $1 billion and then make five to ten times the spread between their cost of funds and 5% on the borrowed money. Let's say the spread is 2.5% for some given period and they borrowed $9 billion. The mREIT will make $275 million ($50 million on the first billion and $225 million on the borrowed $9 billion) or 5.5 times more than Vanguard! Hence the charm of mREITS, if all goes well. As we all know, everything doesn't always go well, and many organizations lost it all in the past 18 months doing this poorly. They went bust because they neglected normal rules of prudence or were simply ignorant. They bought private junk mortgages, now known as "toxic waste", rather than agency guaranteed mortgages. They over-leveraged and got margin calls on their repurchase agreements when repo rates went way up and the mortgages went down in price. And short sellers destroyed their capital structure and undermined repo terms even further. Things that "couldn't happen" did happen. Thornburg Mortgage is perhaps the best known of the mREITS to die, but many banks and hedge funds everywhere did precisely the same.
However, a lot of established and some new mREITS sailed through last year and this doing very well. Naturally a lot of them got sold off in stock price in the general carnage, but mREITS like Annaly (NLY), Hatteras (HTS), Capstead (CMO), Answorth (ANH), etc. all survived and grew since much of their competition for mortgages evaporated. Most mREITS are yielding between 10 and 20% right now, and might continue to do well as short term rates will likely stay low for some time to come. However, if credit crisis conditions resume, LIBOR+ repo rates at which they borrow could go up once more and trim the profit spreads for mREITS. Or repos terms might not even be rolled over. Or some lenders might go under as Lehman, a big repo lender did.
I have bought an initial parcel of NLY and will probably buy more. If I get to 1/3 NLY (and/or others) paying 12.5% and 2/3 in VFIJX paying 4.5%, my combined rate would be 7.167%, a sizeable overall increase. An increase in overall volatility and income would be the result unless I wanted to try to trade the mREIT cycle by monitoring the spread as mentioned above. This chart shows the relative volatilities of NLY, VFIJX/VFIIX and VSGBX/VSGBX. This is a price only chart without dividends. One would clearly prefer to be out of NLY during years like 2005 when the FED was in full tightening mode with short term rates going up a lot.
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