High-Yield REITs Likely to Beat Stocks as Easing Ends

Federal Reserve Chairman Ben Bernanke has indicated that the hurdle for QE3 (a third round of quantitative easing) is very high.

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Other Fed governors have echoed this sentiment and, given the QE2-backlash from politicians and the recent ramp in commodity prices, the Fed wouldn't consider more easing unless deflation emerged and a double-dip recession loomed.

As QE2 ends, there are other significant headwinds facing the economy. In the past two weeks, every single economic report has missed its consensus projection. Consumer confidence posted a disconcerting drop and the S&P Case-Shiller Home Price Index fell to an all-time low.

In many ways, the issues that caused the Great Recession are still prevalent and dogging growth. In this environment, with the government tackling budget cuts and employment stagnating, the Fed funds rate is likely to remain at zero, longer than previously expected.

Last week, as JPMorgan trimmed its estimate for the non-farm payroll number, the bank reiterated its position that interest rates won't rise until the first quarter of 2013. (Friday's report showed that the U.S. economy created only 54,000 jobs in May, less than estimates of around three or four times that number.)

It may be even longer before the Fed hikes rates since it has indicated that paring its multi-trillion dollar balance sheet will be the first step of tightening. As rates stay near zero, fixed-income markets will remain in a sweet spot. And, absent stimulus, yield may trump growth.

Defensive, dividend-paying investments may be strong performers over the next six months. Opportunities abound in REITs and MLPs, in particular, as their value will remain intact, relative to peer investments.

Mortgage REITs, which borrow at near-zero and then use leverage to purchase mortgage-backed securities, are perhaps the most interest-rate-sensitive equity investments. They will continue to offer hefty return on capital and double-digit distribution yields for as long as the Fed remains on hold. One that deserves attention is Chimera Investment.

Chimera is managed by FIDAC, or Fixed Income Discount Advisory Company, a subsidiary of Annaly Capital Management. Annaly is the pioneer and considered best-in-class in the mortgage REIT industry. Chimera focuses on a riskier niche of the mortgage market, targeting non-agency residential mortgage-backed securities. Annaly, on the other hand, purchases strictly agency paper, which carries actual, or implied, AAA-ratings.

Although both REITs offer a double-digit dividend yield, Chimera's has been a bit higher, as of late.

Currently, Chimera sports a trailing 12-month yield of 17% and has a projected 12-month dividend yield of about 15%. Its distribution fell to 14 cents last quarter, from 17 cents a year earlier, as the company posted adjusted core earnings of 15 cents a share.

Interestingly, Chimera isn't exactly an analyst favorite, nor is it unloved. Five researchers rate its stock "buy" and seven rank it "hold." No brokerages advise selling. Barclays, considered one of the best equity researchers in the business, has a bullish stance on Chimera.

Two weeks ago, the British bank issued a research note, explaining its take on Chimera's quarter. Though disappointed that the REIT missed its earnings target by 2 cents, Barclays reiterated its "overweight" ranking and noted that "a reallocation from non-agency to agency" mortgage-backed securities explained the miss.

This risk-off move may signal an alteration of strategy. Apparently, management is expecting a downgrade of non-agency securities and wanted to shift to safer havens. If non-agency sells off sufficiently, that trade may reverse.

Regardless of future allocations, Barclays sees the 14-cent distribution as stable, with potential for modest growth. It expects 60 cents of core earnings for both fiscal 2011 and 2012. Barclays clocks Chimera's leverage, previously relatively low as it targeted riskier mortgage securities, as modest, at 3.8-times.

But, if it continues to transition into agency paper, where the average REIT leverage is 6- to 7-times, it could borrow on the cheap, buy more paper and potentially increase the distribution. Like other mortgage REITs, Chimera's greatest risk is a bump in rates.

Barclays has a "neutral" view of the consumer-finance industry. There is a substantial pipeline of new mortgage REITs trying to IPO, but investor interest seems lackluster as many would rather go with an established REIT, several of which have executed secondary offerings, which appear to be accretive to book value, in this favorable interest-rate environment.

In the pure agency space, Barclays has "overweight" recommendations on both Annaly and Cypress Sharpridge Investments , which currently yield about 14% and 19%, respectively.

Its pick in the non-agency space is Chimera. Investors looking for yield plays, in what could prove a volatile environment, should take a closer look at mortgage REITs.


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