BERKO: Do the math before you buy into a high-yield REIT
Dear Mr. Berko:
I am considering the purchase of $6,000 in Chimera stock and $6,000 worth of American Capital Agency stock, both of which pay dividends that yield 19 percent. How do these companies (there are others, too, with similar high yields) get such big returns when interest rates are so low? Please tell me the risks involved here and if there are any ways to limit my risk.
H.D., Troy, Mich.
Dear H.D.:
Both Chimera Investment Corp. (CIM-$2.72) and American Capital Agency Corp. (AGNC-$28.21) operate as real estate investment trusts (REITs) for tax purposes and therefore must distribute at least 90 percent of their taxable income to shareholders. Both CIM and AGNC own highly leveraged portfolios of mortgage-backed residential securities, collateralized debt obligations and other real estate debt instruments, most of which are either highly rated or government-insured. Their portfolios are structured so that the interest expense of the funds borrowed to purchase this debt is less than the coupon interest of the debt purchased.
For illustrative purposes only, this is how the math works.
AGNC decides to buy a $100,000, 30-year, 4.75 percent, government-backed mortgage bond that will pay $4,750 a year in interest. AGNC will invest $15,000 of its own cash, and the remaining $85,000 is obtained through the company’s issuance of short-term (60 days) commercial paper with a face value of $85,000 at an interest cost of 2 percent, or $1,700 a year. The $4,750 interest received on the bond, less the $1,700 interest cost, will net AGNC $3,050 on a $15,000 investment, which is a dazzling current return of 20.3 percent. AGNC pays out 90 to 95 percent of the earnings, so the return to shareholders averages 19 percent.
As long as short-term rates remain low, this income stream will remain steady. But when short-term rates rise from 2 percent to 2.5 percent, the extra $425 in interest costs reduces AGNC’s income from $3,050 to $2,625 ($3,050 minus $425), of which about 90 percent (or $2,362) is paid to shareholders. This translates to a 20 percent decline in income; still, the resulting 15.7 percent return ain’t bad.
If interest rates rise, then the value of AGNC’s fixed-income bond portfolio will fall and so will the value of your investment, which could drop by 20 percent.
If interest rates stay low – as they are supposed to do well into 2013, according to the Federal Reserve – then AGNC, CIM and others of similar ilk could be attractive investments for a couple of years. If you can sell them a few days before rates rise, you’ve got it made.
But assume that rates unexpectedly rise in July. If they do, AGNC stock will drop like a coconut from a tall palm tree, and when the second coconut falls, AGNC could retreat to $15 a share, where it traded only a few years ago.
The best way to protect yourself against a potential crash in the stock is to place a “sell” order called a “good-till-canceled open stop” at 15 percent below the price you paid. You won’t get caught with your knickers around your ankles. The sell order will execute your shares at $24.25, and your loss will be limited to about $4 a share.
Please address your financial questions to Malcolm Berko, P.O. Box 1416, Boca Raton, Fla. 33429 or email him at malber@adelphia.net. ©2012 Creators.com
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