One Step To Get Paid Every Month

Co-authored by Treading Softly.

When was the last time you used one of those cake mixes that you bought at the grocery store? You know, the one where you just have to add water and eggs, or maybe even oil, and mix it all together, toss it in a pan, bake it, and end up with a wonderful, delicious cake.

I once tried to treat my wife for her birthday by making a cake “from scratch.” I was very careful, tried to follow the instructions to the T, and watched numerous YouTube videos. I put in a lot of effort to show her how much I love her. Her answer? “Thank you Honey, but next time please use a box mix.” A cake made from scratch by a skilled baker has the potential to be much better than a box mix, but in my hands, it was vastly inferior.

When it comes to the market, so many investors try to complicate their investing to a degree far beyond what’s necessary. As a professional income investor, I invest in the market for income. My process is simple: I evaluate an opportunity, I buy that investment if it meets my criteria, I hold it to get paid. There’s no need for me to jump through extra hoops of trying to optimize options, trying to swing trade, trying to bet on momentum movements, or trying to quiz the quant. I simply buy the income. While there might be some experts who can squeeze out a little outperformance with very complicated trading strategies, for most retirees, it is best to keep it simple.

Today, I’ll show you how the simple act of buying an investment can bring in reliable monthly income, highlighting two dividend payers from my personal portfolio.

Let’s dive in!

Pick #1: PFFA – Yield 9.5%

Virtus InfraCap U.S. Preferred Stock ETF (PFFA) is off to a great start in 2024. It started off the year with an increase in the dividend to $0.1675/month, and now the price is reaching 52-week highs.

PFFA is an ETF that departs from the typical strategy of ETFs in two meaningful ways:

1. PFFA is actively managed.
2. PFFA uses leverage.

PFFA has an exchange-traded fund, or ETF, structure, which means that shares always trade near NAV. This is opposed to the significant premium or discount you might see shares trade at for closed-end funds. Yet active management and leverage are two key features that are very common among CEFs and not so common with ETFs.

We’ve been a big fan of the income potential for preferred equity, and as the Fed has hiked, we have viewed the resulting decline in preferred prices as an extended buying opportunity.

The Fed’s hiking cycle has been the longest and deepest drawdown for iShares Preferred and Income Securities ETF (PFF) since the Great Financial Crisis. The COVID crash was one of the fastest declines in PFF’s history—two negative events in less than 5 years.

PFFA has navigated these events and has provided significant outperformance relative to PFF – all while paying a significantly high yield.

PFFA currently yields 9.5%, while PFF is paying just 6.3%. PFFA’s management has proven it can beat the index through difficult times for the asset class, and we are excited to see what it can do through good times.

PFFA’s top holdings include many names that will be immediately recognizable to regular readers: Source.

Higher interest rates are the primary reason that so many preferred shares are trading below par. As interest rates have stabilized, we’ve seen prices recovering, but the opportunities remain plentiful. At our investing group, we’ve been focused on identifying preferred equity opportunities, and have added several new holdings to our portfolio over the past year. PFFA is an option to quickly gain broad exposure to preferred from many companies to double down on the asset class.

Pick #2: AGNC – Yield 14.6%

AGNC Investment Corp (AGNC) is a mortgage REIT that focuses on “agency MBS.” Agency mortgage-backed securities are mortgages that are guaranteed by Fannie Mae or Freddie Mac. If the borrower defaults, the agency buys back the mortgage at par value. As a result, these MBS carry very little credit risk. The investor knows they are going to get par.

That isn’t to say that AGNC’s investment strategy is risk-free. AGNC invests in agency MBS using leverage. Mortgages typically have a 15 or 30-year repayment schedule and are “amortizing” loans with principal payments over the life of the mortgage. AGNC generally uses short-term “repo” financing, a type of secured financing usually for a term of less than six months. So you have a long-term asset and short-term financing. As a result, AGNC’s business model is sensitive to interest rates, changes in the interest rate curve, and the spread between Agency MBS and U.S. Treasuries.

Over the past two years, the yield curve has been “inverted,” meaning long-term Treasury rates have been lower than short-term rates.

The inversion has been reduced as the market is starting to expect the Fed to cut rates. When the Fed actually cuts, we expect the inversion will end quickly.

In addition to interest rates, agency MBS has had unique challenges that have caused it to underperform other fixed-income investments. The Federal Reserve built up a huge position in agency MBS during and following the GFC. Through quantitative easing, the Fed purchased 28% of outstanding MBS. As the Fed has tightened monetary policy, it has stepped back and is no longer a buyer of agency MBS. The market is trying to determine the “right” price for agency MBS. CEO Peter Federico described this process at the UBS Financial Services conference last month:

“When you look back at the relative performance of Agency MBS relative to, say, investment-grade corporates, which is a good comparison. If you look at that relationship, from 2022 to the previous 10 years. The average makes sense in that investment-grade corporates trade typically about 50 basis points in higher yield than Agency MBS. So higher yield for the security that has to lower credit. That shifted about a year ago as the Fed has reduced its footprint in the mortgage market, mortgage spreads have underperformed corporates. And today, that relationship is at a historic wide, meaning Agency MBS, current coupon Agency MBS are trading about 50 basis points higher yield. So you’re of a security that is as the full credit support of the U.S. Government trading 50 basis points above investment-grade corporates.

So when you look at it from that perspective and you look at Agency MBS relative to Treasurers, I think Agency MBS is one of the cheapest fixed income investments available to investors. It takes time for investors to reallocate and move out of other securities out of corporate bonds, out of treasuries into Agency MBS, but I think that transition is slowly starting to happen, but it does take time.”

I’ve frequently said that low prices benefit the buyer of an asset. This is a concept that many find very easy to accept on the surface. If you go to a store and prices are low, you are happy as a potential buyer. Yet when we are shopping in the market, we look at an investment with lower prices and so many conclude that it is a “bad” investment. Indeed, a surprisingly large number of potential investors will sell an asset because its price is low, and will buy another asset because its price is high! They will look at the charts and conclude that because the price went up or down over a 1, 3, 5, or 10-year period, the price is most likely going to continue going in that particular direction.

The purpose of AGNC’s existence is to buy agency MBS. That’s what the company does. While it might occasionally change the size of its portfolio, it is never going to be a significant seller of agency MBS. As a buyer of agency MBS, AGNC wants MBS prices to be low. In other words, it wants the spread between agency MBS and Treasuries to be wide.

“I think this range that we’re trading in now may be the range that we stay in for the reasonably near term. Because the Fed will be continuing to back out of the mortgage market, even when the Fed tapers its mortgage asset portfolio and ultimately stops the runoff of its balance sheet. They will likely continue to reduce their mortgage holdings in favor of treasury holdings. So against that backdrop over the next year or 2, I would say that the current level is probably the clearing level for mortgages, which would be very good for our business. What we are looking for in our business, obviously, as a levered investor in Agency MBS spreads essentially, we want spreads to be wide and we want them to stay wide. And that may be in the environment that we’re entering right now.”

Note that wide spreads are what has caused book value to plummet for AGNC in 2022, and stay down for the past two years. Source.

What kind of a crazy person wants the value of the assets they hold to decline? The kind of crazy who is in a position to buy more assets. The forward returns for agency MBS are as high as they’ve ever been. Even as book value has moved, the returns that the portfolio is capable of producing have remained steady.

When asked about dividend stability, Peter Federico said:

“So what we’ve seen over the last 2 years is despite all the movement in our book value, our dividend yield has moved up and down, consistent with generally speaking, the economic earnings in our portfolio because that book value is being driven by spread changes as opposed to other economic factors like interest rates. Those certainly all come into play, and they do have an impact on our book value. But it’s been largely driven by the dramatic move in mortgage spreads over the last 2 years.”

There is still a lack of clarity about when the Fed will cut, and how aggressively they will cut. AGNC has to hedge itself against interest rate volatility, and ensure that it maintains liquidity so it is never forced to sell in an adverse environment. This has restrained it from leveraging up.

MBS prices are objectively low today relative to other types of fixed-income. Despite having less credit risk, agency MBS is trading at a higher yield (lower price) than corporate debt! AGNC recognizes that lower prices are a great opportunity for investors who are buyers. We recognize that AGNC’s low prices are an excellent opportunity for buyers like us.

Conclusion

My personal portfolio holds several monthly and also quarterly payers, so I can collect strong income very regularly. Regardless of whether something pays me monthly or quarterly, we go through the same rigorous analysis and research to ensure the income is dependable.

At the end of the day, I am finding that fixed income-focused investments like PFFA and AGNC are set up to be able to provide me with strong income now, as well as strong capital returns in the future as interest rates decline. Everyone is playing the guessing game of when interest rates will begin to drop. Regardless of whether it is in a few months or a few years, the consensus is that interest rates will not stay this high forever. So, I’ve built a portfolio that will benefit from declining interest rates with holdings like PFFA and AGNC, as well as to benefit from interest rates as they remain higher for longer within my various BDC holdings that we’ve covered before. This way, my portfolio can benefit from whatever the market and the economy decide to do.

When it comes to your retirement, you don’t want to have to worry about every wind of change that could blow across your sails. The larger the vessel, the more stable it is in different weather conditions. So, I have built my portfolio to be like a ship that can weather the strongest of storms. It still needs a captain. It still needs a crew. But unlike a small sailboat that can get topped over by a single wave from the wrong direction, my barge of a portfolio can withstand a powerful storm, whatever it may be, and still take me to my destination. If your portfolio isn’t able to provide you income unless you constantly have to batten down the hatches and throw off your cargo to try and survive those storms of life, perhaps it’s time to change how you invest in the market.

That’s the beauty of my Income Method. That’s the beauty of income investing.