In my last post, I hinted at using QE2 to your advantage by investing in companies that benefit from a steepening yield curve. But I didn’t have time to get in to specifics. Which is what I’ll do right now, seeing that I have a couple of hours to spare at the Fort Lauderdale airport.

The Federal Reserve let the market know that it plans to keep short term interest rates at extremely low rates for the next few quarters (if not longer). Companies that can borrow short term, can do so at very low rates. So long as you have AA-rated collateral, you can borrow money at about 0.30% on a 30 day basis. If you plan to borrow for a longer term, you just need to keep “rolling” your loan every 30 days or so.

So if you can invest in a AA-rated bond that pays say 3% or 4% and borrow money at 0.30%, you’re going to profit from the spread. Do such bonds exist?

They do – they’re called Agency RMBS and they’re just large pools of single-family residential mortgages that are bundled together in to large multi-million dollar securities and guaranteed against default by a government sponsored agency such as Freddie Mac or Fannie Mae. They also yield about 3.75% or higher.

So you can borrow money at 0.30% and invest it at 3.75% and you’re guaranteed against loss of principle by a government agency! Sounds too good to be true? Well it gets better!

Companies that use this business model to make money are set up as REITs and pay out a hefty dividend to shareholders. Companies like Annaly Capital Management (NLY),  Hatteras Financial Corp (HTS), Cypress Sharpridge Investments (CYS) are mortgage REITs that are set up to do exactly this. And they all pay approximately 15% in dividends.

An RMBS is basically a bond and all bonds have 3 types of risk:

1. Credit Risk
2. Prepayment Risk
3. Interest Risk

Companies which invest in Agency MBS don’t suffer from credit risk. If the borrower of the mortgage defaults, the government-sponsored agency just buys it back and you get your money back. There is no fear of loss of principle!

Prepayment risk is when the borrower pays off the loan early and returns your principle back to you. This usually happens in environments when interest rates are dropping and borrowers can refinance their mortgages at a lower rate. If you get your money back early, you need to reinvest the money, typically at a lower rate. Given that mortgage rates are so low and refinancing is much more difficult than it used to be, the risk of prepayment is limited. There are some always some prepayments though which occur as regular amortization of the loan. Some companies will calculate how much of their portfolio and try to enter forward contracts to purchase more RBMS and thus mitigate the prepayment risk. CYS is one company that does this.

The third and major risk is interest rate risk. As the cost of borrowing increases, the spread between borrowing and invests decreases. Your profit margins drop and are no longer able to make the kind of returns you’re used to. Again some companies hedge against this event, and incur some cost in doing so. But hedging maintains long-term predictability of cash flows and may be worth the drop in potential yield. Again CYS does this and it’s net spread after hedging is 2.55%. It also uses 7.5:1 leverage to maintain a $4.5 billion portfolio against $600 million equity position. When you earn a 2.55% spread and can leverage up 7.5%, that’s a whopping 19% yield! CYS has about a 17% dividend yield.

Disclosure: I bought a 33% position in CYS on Friday and am going to be buying more under $13.50.