I rarely say an income investment is categorically off the table for the High Yield Wealth portfolio …

But there are instances.

One instance centers on real estate investment trusts (REITs).

Don’t misunderstand. REITs can be dependable, high-yield income sources. High Yield Wealth recommendation Gladstone Commercial Corp. (NYSE: GOOD) is an example.

[ad#Google Adsense 336×280-IA]Gladstone owns a diversified portfolio of commercial properties.

In industry jargon, Gladstone is an equity REIT: it makes money leasing properties it owns.

This simple, model produces a steady stream of reliable income when done well.

Gladstone does it well.

But there are other types of REITs.

One REIT incarnation is garnering significant investor attention.

I’m referring to mortgage REITs, which resemble finance companies more than landlords.

Mortgage REITs borrow at the low-rate offered by short-term instruments, like repurchase agreements, and buy Fannie Mae and Freddie Mac agency mortgage-backed securities (MBS), which yield around 2.7%. (Some also buy private agency MBS, which yield a little more.)

Mortgage REITs make money on the difference between the low interest rate they pay on their financing and the higher rate received on their mortgage assets. Add leverage to the spread and mortgage REITs are able to generate double-digit yields that are 50% to 100% higher than the 8% offered by an equity REIT like Gladstone.

In this market of ultra-low short-term rates, the mortgage REIT model imparts a license to print money. Two of the more popular mortgage REITs – Annaly Capital Management (NYSE: NYL) and American Capital Agency Corp. (NASDAQ: AGNC) – both yield above 15%. By offering such rich yields, it’s easy to understand why mortgage REITs are drawing investor interest.

So what’s my beef with these high-yield mortgage REITs?

Interest-rate risk is at the fore. A sudden spike in interest rates would simultaneously lower the value of the MBS collateral while raising the cost to fund that collateral. Margins would be squeezed (or even eliminated) and profits would fall or would turn to losses.

In addition, the very act of borrowing short to buy long is itself a risky endeavor; one much riskier than most investors appreciate.

Whenever there is a shock to the financial system, short-term lenders are the first to head for the hills. This leads to the dreaded “liquidity crisis” where a firm is unable to secure financing for daily operations. The firm subsequently seizes (Bear Stearns and Lehman Brothers were recent examples) and becomes technically bankrupt.

Mortgage REIT proponents counter that these risks are hedged through interest-rate swaps. Fair enough, but hedges are only as effective as the financial strength of the counter party on the other side of the transaction. American International Group (NYSE: AIG) was once a highly rated counter party in the credit-default-swap market prior to the 2008 financial meltdown. Post-meltdown, it was a bankrupt counter party.

Mortgage REIT risks are further magnified by rapid industry growth. The Wall Street Journal reports that mortgage assets held by mortgage REITs have more than quadrupled to $400 billion since 2009. More mortgage REITs are exposed to more risk.

In this Fed-manipulated credit market, market factors are currently aligned in the mortgage REITs’ favor. The problem is, as time progresses these factors tend to become less favorably aligned. In other words, the longer the factors are in your favor, the less likely they will remain aligned to your favor in the future.

In my opinion, investing in mortgage REITs is an exercise in yield reaching. And as analyst Raymond DeVoe Jr. trenchantly pointed out a few years ago, “More money has been lost reaching for yield than at the point of a gun.”

— Ian Wyatt

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Source: Wyatt Investment Research