The positive Brexit vote in the United Kingdom has turned much of what the financial world was expecting on its head. Rapidly falling bond interest rates have replaced the fears of interest rate increases from the Federal Reserve Board. The record-low rates on the U.S. 10-year Treasury bond will have a very negative effect on one type of high-yield income stock. Now is the time to clear these stocks out of your portfolio and add some more stable high-yield dividend payers.
The stocks to ditch are the high-yield finance real estate investment trusts (REITs) that generate cash flow from owning portfolios of federal agency guaranteed mortgage-backed securities (MBS). You will often see this group of companies identified as agency mREITs. However, since the government-backed mortgage securities only yield 2% to 3%, these REITs use significant amounts of leverage to boost the net yield on their MBS portfolios.
A hypothetical example such as this is the standard in the industry: A mREIT can buy agency MBS with an average yield of 2.5%. The company can borrow money at 1.0% for a net yield of 1.5% on bonds purchased with borrowed money. The REIT leverages its equity six times to buy a MBS portfolio equal to seven times the equity in the company. As a result, the net yield on equity is 1.5% times the 6 times leverage plus 2.5% on the MBS amount covered by the equity, for a net yield of 10.5% on equity. The equation written out looks like this: (1.5% X 6) + 2.5% = 11.5%
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Out of that net interest earnings, the REIT must pay management expenses. Also, since both short-term interest rates (the borrowing costs) and long-term rates (MBS yields) fluctuate, the company must invest in interest rate hedges to try and lock in as much of that interest rate spread as possible. MBS pricing can get very complicated as rates change, so hedging is not an exact science. History has shown us that when rates or prices move significantly, hedges do not protect earnings or profits. At best, they keep a company out of bankruptcy court until the markets return to more normal conditions. We all had a taste of this exact situation when the energy markets crashed. Many upstream oil producers with significant hedging still did not survive.
