How to Win Bernanke's War on Savers with a 19% Yield

There is no other way to put this... With his zero interest rate policy (ZIRP), U.S. Federal Reserve Chairman Ben Bernanke has declared a virtual war on the nation's savers.

That's why savings-conscious investors have been forced out into the markets these days in search of higher yields.

Between 10-year notes offering yields under 2% and CD rates hovering near 1%, savers have been left little choice.

It is one of the reasons why high-paying dividend stocks have been in demand ever since the ZIRP crisis began.

For savvy investors looking to boost their yield, there's only one place to look...

They're called mortgage REITs, and they offer investors the chance to collect some of the highest dividend yields available today.

In fact, one of these investments is actually paying a 19% yield, right now!

That's not a typo. Double-digit yields like those really can be found if you know where to look for them.

I'll tell you more about this company in a moment. But first I'd like to explain to you what mortgage REITs are all about.

Mortgage REITs Explained

Real Estate Investment Trusts, or REITs, came into existence because of U.S. President Dwight Eisenhower's "Cigar Tax Excise Tax Extension" of 1960. Under this initially obscure tax provision, REITs can avoid corporate income tax, provided they invest in real estate-related assets and pay out at least 90% of their income in dividends to investors.

Mortgage REITs, as their name suggests, invest in residential and commercial mortgages.

Within the residential mortgage REIT category, some invest in agency-guaranteed REITs while others specialize in REITs that are not guaranteed.

Given the recent default rate on home mortgages, investors would be wise to concentrate on guaranteed agency mortgage REITs. This is due in part to Ben Bernanke's monetary policy since 2008.

Let me explain...

How Mortgage REITs "Goose" Yields

If agency mortgage REITs simply bought home mortgages on an unleveraged basis, they would be safe but boring investments, because their yield would be only about 4% currently.

Of course, their principal would be government guaranteed, though it would fluctuate with the level of interest rates.

But since there's not a lot of money involved in selling 4% yields to retail investors, mortgage REITS goose their returns by using leverage.

They borrow in the short-term market, usually by entering into "repurchase agreements" with the mortgages they have bought (they can do this because of the guarantee on the mortgages).

Since Bernanke has kept short-term interest rates close to zero for over three years, this is very profitable, maybe adding 2.5% to the yield of an unleveraged mortgage portfolio after expenses for each unit of leverage.

Thus, a portfolio leveraged 1-to-1 (with $100 of equity and $100 of repurchase agreements) would yield roughly 6.5%, while a portfolio leveraged 2-to-1 would yield about 9%, etc.

One mortgage REIT,American Capital Agency Corp. (Nasdaq: AGNC)actually takes this to an extreme, with leverage of about 9-to-1.

Consequently, AGNCmanages to pay out a dividend yield of 19.9% -- and earn somewhat more than it pays out.

How Rising Rates Effect Mortgage REITs

However, there are no free lunches in life.

Consequently, what a mortgage REIT gains in yield through leverage, it gives up in risk.

Of course, there is little danger of principal loss on the mortgage investments - they are government guaranteed. That much is secure.

However, rises in interest rates affect mortgage REITs in two ways.

If short-term interest rates rise, the spread between their funding cost and what they earn on the mortgages becomes less profitable, and their yield declines.

More dangerous, if long-term interest rates rise, the value of their mortgage portfolio declines. Since they are leveraged, it does not have to decline all that far for their capital to be affected.

For instance, with $9.00 of debt to every $1.00 of equity for a company like AGNC, a rise of about 2% in long-term interest rates would make the company insolvent.

That's the risk. You can hedge against it using swaps and options, and AGNC does so, but it's unlikely that hedges could cover a really sustained upward move in interest rates.

The upside is that Bernanke and the Fed have said that they do not intend to let short-term rates rise before the middle of 2013.

They also have a $400 billion "Operation Twist" program of selling short-term Treasuries and buying long-term Treasuries. That works against any sudden rise in long-term Treasury yields.

So to a large degree when you invest in REITs, you are trusting Bernanke. But that has worked for more than three years, and there's no reason it should not continue to do so.

However, as a responsible investor, if you buy a mortgage REIT you should follow monetary policy closely, and reassess your position every six months or so.

Two Ways to Invest in Mortgage REITs

That being said, here are two mortgage REITs to consider:

• American Capital Agency Corp. (Nasdaq: AGNC): AGNC is large and liquid, with $47 billion of assets and market capitalization of $6.3 billion. As I discussed, the company pays a $1.40 per share quarterly dividend, giving it a yield of 19.9%. It is priced about 5% above book value and is leveraged 9:1 - which makes AGNC a high risk, high-return proposition.

• Annaly Capital Management (NYSE: NLY): NLY is also very large and liquid, with $100 billion of assets, but leverage is only about 6:1. NLY pays a dividend of $0.57 per share, while priced at only a 1% premium to book value. Thus, overall this is a more conservative choice.

So don't let the Fed's war on savings keep you from earning the yields you deserve. The right mix of high-yielding dividend stocks can help replace what the Fed has taken away.

News and Related Story Links:

• Money Morning:
  The Income Investments You Need to Focus On Right Now
• Money Morning:
  Master Limited Partnerships: A Simple Way to Put More Cash in Your Pocket
• Money Morning:
  The Treasury Investment That's WAY Better Than Treasury Inflation Protected Securities (TIPS)