TAKING STOCK: Tread carefully and do the math when looking at REITs

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. I'm primarily an income investor and don't mind taking a little chance to earn a much bigger return, but I don't know how to evaluate the risks in this case. Your thoughts would be greatly appreciated. HD, Troy, Mich. Dear HD: Both Chimera (CIM-$2.65) and American Capital Agency (AGNC-$28.54) operate as real estate investment trusts - 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 an $85,000 face-value short-term (60 days) commercial paper at an interest cost of 2 percent, or $1,700 a year. The $4,750 interest received, less the $1,700 interest cost, will net AGNC $3,050 on a $15,000 investment, which is a dazzling, nose-bleeding, mind-blowing, tan-fastic, expialidocious current return of 20.3 percent. And AGNC pays out 90 to 95 percent of the 20.3 percent earnings, so the return to shareholders averages 19.0 percent. That's how this scheme works. And as long as short-term rates remain low, this income stream will remain steady. But when short-term rates rise from 2.0 percent to 2.5 percent (that's one-half of 1 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 chopped liver. Meanwhile, if interest rates rise, then the value of AGNC's fixed-income bond portfolio will fall and so will the value of your investment in AGNC stock, which could drop by 20 percent. So you must be mindful of the Cockroach Rule: When you turn on the kitchen light at midnight and a cockroach skitters across the tiles, there's a 98.6 percent degree of certainty that a second, a third and a fourth will follow. In other words, there will soon be more 0.5 percent increases as the months progress and further declines in the market value of your AGNC stock. Now, if you got this in your head, than you'll have it in a nutshell. If interest rates stay low - as they are supposed to well into 2013, according the Fed - then AGNC, CIM and others of similar ilk could be attractive investments for a couple of years. And if you can sell them a few days before rates rise, then you've got it made in the shade. But assume that rates do not stay low and 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-'til-cancel-open-stop" at 15 percent below the price you paid for the stock. So if rates drop sooner than you expect, you won't get caught with your knickers around your ankles. The open/stop 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 8303, Largo, FL 33775 or e-mail him at mjberko@yahoo.com. Visit Creators Syndicate website at www.creators.com. © 2011 Creators Syndicate Inc. Published: Fri, Jan 20, 2012