I have been writing about where to invest to get a good yield in the current market. That is only half the problem, however. There is also the issue of investments to avoid.
Right now, there are two areas with alluring yields that I do not believe are worth an investment. These two are the mortgage REITs and the business development companies also known as BDCs.
Mortgage REITs are companies that mostly invest in mortgages. Some only buy the mortgage backed securities issued with government guarantees. Others buy mortgage backed securities from private issuers. Normally, these companies borrow against their holdings at low short-term interest rates and then invest in higher yielding long term bonds. There are many different paradigms used by the MREITs, but they each face certain problems that keep me from currently investing in these entities. First, they do not have any major items on the horizon that could improve their financial positions without a major increase in risk. The MREITs profit from a lowering of short term rates, but these rates are as low as they can possibly go. The MREITs also profit from higher long term interest rates and therefore higher mortgage rates, but with the latest Fed easing, there is essentially no likelihood in the next two years of such higher rates. Further, rising rates only benefit the MREITs on new investments; bonds that they already own will decline in value if the interest rates rise. Most MREITs have the ability to substantially increase their leverage, but with the near term prospects for interest rates being government by the Fed, it makes little sense for such an increase in risk to be undertaken.
MREITs also face some ongoing problems. The biggest problem is the Federal Reserve and its ongoing effort to lower mortgage rates. As mortgage rates fall or even stay a the current low rates, folks across the country can refinance their homes at lower interest rates. As the mortgages are prepaid, the MREITs get portions of their holdings redeemed and there are only new investments available at lower rates. This phenomenon keeps downward pressure on the interest rate spread that the MREITs can obtain on their funds. for the moment, the MREITs are being helped by the difficulties that many home owners are experiencing with refinancing. Rates may be lower, but there are many home owners who no longer meet the qualifications for a new mortgage. If the government ever takes effective steps to allow refinancing of these homes, there will be a massive slug of prepayments which could really hurt the MREITs. There have been numerous attempts by the Obama administration to allow such refinancing, but they have all been failures, thus helping the MREITs.
So, MREITs have little prospects for improvement and a mid term prospect for lower incomes and distributions. Under current market conditions, I would stay away from them. Their day will come again, but right now they are just too risky.
Business Development Companies make loans to and investments in corporations that are having trouble getting sufficient funding from banks and the bond markets. Because they are not banks, they can receive payment for the loans, in part, by taking equity positions in their borrowers. This provides an up side for the BDCs that banks do not have, but it is not enough to make up for the lower credit quality of most of the borrowers. If the world moves further down the road to renewed recession, the BDCs will be the ones who are most at risk due to failure of their borrowers. There is no doubt that the BDCs pay a nice return, but right now, it is simply not high enough to take the risk of this class in my opinion.
For those who nevertheless believe that the BDCs are a good place for some of their portfolio, I recommend Ares Capital (symbol ARCC). It is one of the stronger and better managed BDCs. It also has options which can be used to enhance the dividend return through just out-of-the-money covered call writing.
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