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2Q 2013 | Report #1
Oxford Income Letter Special Report:
Spread Trusts: How to Double
Your Money on the Debt Bubble
By Ryan Fitzwater, Research Team, The Oxford Club
NOTE: The Oxford Club is not a broker, dealer or licensed investment advisor. No person listed here should be
considered as permitted to engage in rendering personalized investment, legal or other professional advice as an
agent of The Oxford Club. The Oxford Club does not receive any compensation for these services. Additionally, any
individual services rendered to The Oxford Club members by those mentioned are considered completely separate
from and outside the scope of services offered by The Oxford Club. Therefore if you choose to contact anyone listed
here, such contact, as well as, any resulting relationship, is strictly between you and the Pillar One service.
The
Letter
105 West Monument Street | Baltimore, Maryland | 21201 | 410.864.1751
Oxford Income Letter Special Report: Spread Trusts: How to Double Your Money...
The greatest bond bubble in world history is here – right now.
The Federal Reserve, foreign governments, financial firms and individuals are more heavily
invested in U.S. Treasuries than at any point in history.
Foreign governments alone hold more than $5 trillion worth of Treasuries.
And the United States keeps funding its ballooning debt by selling more and more U.S. Treasury
bonds.
But to understand what’s coming, you must first understand this…
America’s debt situation is much, much worse than the politicians are letting on.
The General Accounting Office reports that our national debt now stands at almost $16.8
trillion.
Just so that you could picture it a little better, $16 trillion is a stack of crisp $100 bills 7,465
miles high...
What does that mean in real-world terms?
U.S. Debt Has Crossed the 100% Threshold
Here’s one way to understand how awful the situation is. Simply compare our debt with our
ability to pay back that debt.
■
16
14
% GDP
120%
Total Debt to GDP %
■ Total
100%
Debt Level $
80%
12
10
60%
8
40%
6
4
20%
2
2
2012
2011
2010
2009
2008
2007
2006
2005
2004
3/2013
If history is any indicator, it doesn’t
2003
0%
2002
So what happens after debt crosses the
100% threshold in the midst of an
economic downturn?
$Trillions
18
2001
Right now, our annual GDP stands
at about $15.1 trillion. That means
our debt has passed 100% of our
production… and it’s headed straight
up!
Washington’s debt has surpassed
100% of GDP…
2000
As you probably know, gross domestic
product (GDP) reflects the dollar value
of everything the U.S. produces each
year.
Oxford Income Letter Special Report: Spread Trusts: How to Double Your Money...
peak… or flatten… or go down.
It skyrockets.
Stanford University and Hoover Institution Economist John B. Taylor has crunched the
numbers. According to his research, now that we have passed the 100% threshold… this thing
will take off like a rocket leaving Cape Canaveral.
And as I’ve just shown you… we’ve already gone past this point of no-return.
The Bond Bubble Has Already Passed “Terminal Velocity”
The bubble reached “terminal velocity” on August 5, 2011. That day, the S&P downgraded U.S.
Treasuries for the first time in history. The formerly AAA-rated securities now hold an AA+
rating.
It wasn’t surprising that bond investors panicked at the downgrade.
What was surprising was their next move. They piled into more Treasuries to protect against the
loss of value… in Treasuries!
Crazy, I know. But the headline from Reuter’s told the whole story:
“U.S. bonds soar on worry about downgrade’s impact.”
We haven’t seen this kind of irrational behavior since investors were plowing millions of dollars
into companies with no sales during the dot.com bubble.
Even more shocking is this: 17 countries now have better credit ratings than the U.S.A.
Guernsey, Lichtenstein, Finland, Austria and even France! All represent a better credit risk,
according to the major credit ratings agencies.
Ultimately, no market can escape the force of gravity forever. Radical market imbalances always
correct themselves.
And right now, the biggest forces in the bond market are preparing to implode the Treasury
market from the inside… once and for all.
Respected UBS economist Larry Hathaway calls the coming event “one of those once-in-adecade calls.”
In a report sent to clients earlier this year, Hathaway said:
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Oxford Income Letter Special Report: Spread Trusts: How to Double Your Money...
“We believe the trend toward higher yields in the months, quarters and years ahead is established. The
source of the sell-off is clear – an improved and more durable global economic recovery, particularly in
the U.S.”
The situation is unsustainable. And the consequences will be systemic.
Why? Because Treasuries form the backbone of portfolios throughout the world.
Enter the “Bond Vigilantes”
So what force will finally blow this bubble apart?
They call them the Bond Vigilantes.
These are the biggest players in the bond market – the guys with the most money at stake.
Since Alexander Hamilton founded the U.S. Treasury market in 1792, the vigilantes have
determined long-term rates.
For decades they bought 90% of the Treasuries at auction. And they submit the bids that
determine how much interest the Treasury Dept. must pay on the bonds.
These power players include the big hedge funds, and the governments of China and Japan. They
also include the most powerful U.S. bankers.
When they feel the U.S. government’s spending is getting out of control… that it’s not handling
its finances wisely… they’ll demand higher interest rates for the perceived risk.
For example, soon after Bill Clinton took office, he announced big spending plans on “HillaryCare.” The bond vigilantes responded immediately by refusing to bid on government debt,
sending yields through the roof. Clinton was forced to back off.
Today, the current administration is spending money it doesn’t have – adding to our record debt.
Meanwhile, bonds are priced for Armageddon – when reality says we’re in a recovery.
Yes, it might be a slow-burn recovery. But the end of the world is not here, or even near.
The bond vigilantes realize this, and they’ve begun selling off in small, discreet batches.
That’s why we’ve seen “mini spikes” in interest rates at several auctions in the past six months.
Take a look.
This is called “testing resistance.” But as you can see above, the 10-year T-Note keeps hitting
higher highs with each spike.
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Oxford Income Letter Special Report: Spread Trusts: How to Double Your Money...
Very soon, according to our sources
inside the world’s biggest banks, we
will see a massive spike in interest
rates.
Interest Rate on 10-Year Treasuries
2.4
2.2
What will happen is that the vigilantes
won’t show up for an auction in 10year bonds.
Mar13
Jan13
Nov12
Jul12
Rates edging higher
Sep12
News of this auction will spread
around the global financial world and
it will signal the official end of the 30year Treasury bubble.
1.8
May12
And the few players who do will
demand a huge interest rate on the
bonds they purchase.
2.0
1.6
1.4
And from there, the dominos will fall – quickly.
What Will Happen When the First Domino Falls?
Under the weight of a staggering debt, bonds will follow their natural course.
They will tank – and interest rates will soar.
By our calculations, the coming event could slash the $98 trillion bond market in half.
Interest rates on the 10-year Treasuries could soar 692% or more. That’s if they merely
return to their historic highs of 15.84%.
Imagine trying to finance a home at 40% interest. Imagine buying a car or paying off credit
cards charging 50%.
More importantly, imagine what that will do to the value of your bond portfolio. With the new
bonds paying higher rates, all existing bonds will tank in value.
We’re talking about a 50% systemic “haircut”…
When exactly it hits cannot be said with certainty. What can be said is that the bond bubble is set to
explode.
And there are a few simple things you can do – now – to be prepared whenever it happens.
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Oxford Income Letter Special Report: Spread Trusts: How to Double Your Money...
First, Build a Protective Wall Around Your Portfolio
The first thing you want to do – now – is move your bond portfolio from long-term Treasuries into
short-term T-bills.
Why? Because Fed Chairman Ben Bernanke has promised to keep short-term rates low through
mid-2015.
Indeed, Bernanke can control the short-term Fed Funds rate. He can virtually dictate rates on
30-day, 90-day and 1-year Treasuries.
He’ll keep rates low because he has no choice. He must keep the money-throttle wide open in
his desperate bid to heat up the economy.
Considering the tepid recovery the U.S. has entered, Bernanke has the money-throttle wide
open. The Fed Funds rate is at 0.25%. A quarter of a percent!
That’s about to create the opportunity of a lifetime. Here’s how…
Second, Strike for Huge Gains With mREITs
When the bond bubble bursts, interest rates on long-term Treasuries will soar – up to tenfold or
more.
Yet Bernanke will keep short-term rates pinned to near zero.
That will create a massive “spread” between short-term and long-term rates.
As that spread widens over the next two to three years, one investment is poised to soar.
They’re called mREITs, which stands for mortgage Real Estate Investment Trusts. Or, what we
have nicknamed here in The Oxford Club Research Department, Spread Trusts.
How do “Spread Trusts” work in a bond bubble environment?
Simple.
Spread Trusts borrow money at short-term rates and lend money at long-term rates.
That means as the spread widens between short and long-term bonds… these mREITs will soar.
Let’s say a Spread Trust borrows $1 billion at 1% interest. It turns around and lends that same
billion dollars at 5%. And it pockets every penny in between… while doing nothing.
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Oxford Income Letter Special Report: Spread Trusts: How to Double Your Money...
It pockets the “spread,” in other words.
We will soon witness what could be the widest spread in the history of Treasuries, as I’ve
explained.
And we have Bernanke to thank for it!
Think about this: He has pledged to keep short-term rates pinned at near-zero for at least the
next two years! Meanwhile, when the long-term rates soar, that spread will explode (it’s fairly
wide already).
The government has never created such an obvious – almost unfair – investing opportunity. The
problem is that most investors have no idea what’s coming… even if they’ve heard of Spread
Trusts.
And that’s too bad for them. Because we believe these stocks represent the single best way to play
the coming burst in the bond bubble.
But even now the cash-flows are so outrageous that Spread Trusts pay out double-digit dividends.
And we’ve pinpointed three Spread Trusts that deal only in the safest govt.-backed assets. Never
before have we seen a “govt.-guaranteed” opportunity like this.
In light of the historic bubble in Treasuries, we could not think of a more perfect investment. So
let’s get to it…
Spread Trust #1: American Capital Agency Corp. (Nasdaq: AGNC)
Based in Bethesda, Maryland, and founded in 2008, American Capital is a mortgage REIT that
invests in government-backed agency mortgage securities.
These are government-guaranteed investments. It doesn’t get any safer than this.
All of American Capital’s principal and interest payments are guaranteed by the
Government National Mortgage Association (GNMA) or U.S. Government-sponsored
entities like the Federal National Mortgage Association (FNMA) and the Federal Home
Loan Mortgage Corporation (FHLMC).
If you are wondering how a company that solely invests in mortgage securities can earn a returnon-equity (ROE) over 14% when most mortgage-backed securities yield around 3%, give or
take, you are asking the right questions.
The answer lies in leveraging.
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Oxford Income Letter Special Report: Spread Trusts: How to Double Your Money...
Leveraging With Repos
American Capital funds its investments mostly through short-term borrowings structured as
repurchase agreements, better known as repos.
A repo is similar to a secured loan. What mREITs like American Capital essentially do is put
some of their assets up as collateral to secure a cash loan.
So American Capital borrows via short-term loans (usually lasting only 30 days) and uses the
money to buy mortgages that are packaged and guaranteed by government sponsored entities.
These mortgages earn the company interest. At the end of the thirty days, American Capital will
borrow again to pay off the previous loan.
So where do they make their money if they are on a constant cycle of borrowing?
Simple: off the short-term and long-term spreads in borrowing.
Because the short-term interest rates that American Capital pays to borrow money are typically
lower than the long-term rates it earns on mortgage-backed securities, it makes its profits in the
spread.
Now you can really understand why we call them “Spread Trusts.”
It is a very clever way to run a business. It uses a steady cycle of borrowing at low rates over and
over while it continues to get higher rates on long-term mortgages.
It’s All in the Spread
Now imagine how much profit
American Capital can capture when
the bond bubble bursts and interest
rates on long-term Treasuries soar
while the Fed keeps short-term rates
pinned to near zero.
American Capital’s 2013 Net Income is Projected
to Hit $1.43B, that’s 1,112% Higher than its
2009 Net Income of Just $118M
$1.6B
$1.4B
$1.2B
$1.0B
$800M
A massive spread between shortterm and long-term rates will send
American Capital’s profit margins
through the roof.
$400M
8
FY2013e
FY2012
FY2011
FY2010
FY2009
$200M
FY2008
As a REIT, American Capital is not
subject to federal income tax, but this
$600M
Oxford Income Letter Special Report: Spread Trusts: How to Double Your Money...
means it has to give a majority of its profits to investors.
So unlike other publicly traded stocks, where greedy management can siphon off profits, REITs have to
provide at least 90% of their taxable income to shareholders. And this is done through the company’s
oversized dividend payments.
This is why American Capital currently pays a dividend of $5, which works out to a 15.40%
dividend yield.
As that spread widens between short-term and long-term rates over the next two to three years,
the dividend payments could get even bigger.
American Capital’s first quarterly dividend payment was $0.31 back in June of 2008. In its most
recent quarter, that payment hit $1.25. That’s an increase of more than 303% in 4 years.
And we can only imagine the size of its dividend payments once the bond bubble bursts and
long-term rates shoot through the roof. At this point in time, the sky appears to be the limit.
Action to Take: Buy American Capital Agency Corp. (Nasdaq: AGNC) at market. And use our
customary 25% trailing stop to protect your principal and your profits.
Spread Trust #2: Hatteras Financial Corporation (NYSE: HTS)
Just like American Capital, Hatteras is an mREIT that acquires adjustable-rate and hybrid-rate
residential government-backed mortgage securities.
Based in Winston-Salem, North Carolina, Hatteras began operating in 2007 and it has more
than survived the current sluggish economy.
Since the company began trading publicly on April 30, 2008, it has returned over 118.19% to
investors.
To give you a better idea on Hatteras’s return to shareholders, a $10,000 investment back on the
day it started trading in 2008 would now be worth $21,130 had you reinvested your dividends.
That is an annualized return of 16.78%.
And as we have noted above regarding the coming interest rate spread… the best is yet to come.
New Company, Old Management
Hatteras is externally managed by Atlantic Capital Advisors, adding a decade more experience in
mREIT operations to Hatteras’ own management team.
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Oxford Income Letter Special Report: Spread Trusts: How to Double Your Money...
This is what we like to see… experienced management. There’s no substitute for that.
Atlantic Capital has managed ACM Financial Trust, a privately held mREIT, since it was founded in
1998. Most of senior management has worked together for almost ten years at this point.
Experience at Atlantic Capital’s management brings a level of oversight to Hatteras that doubles
the time the company has even existed.
Its goal is simple: provide income to shareholders through quarterly dividends. And this income
comes from the spread between interest income from its mortgage portfolio and the interest costs
of its borrowing and hedging activities.
Wall Street Is “All-In” on Hatteras
While researching and making a stock pick, investors can always feel some comfort when big
players in the industry are holding large shares of a company.
Today, some of the world’s top mutual funds and investment banks hold shares of Hatteras… and they
are not small positions.
Investment juggernaut BlackRock Group is the second largest shareholder of Hatteras’ stock,
owning over 5.4 million shares. That’s a 5% ownership.
Other big names include Vanguard Group, T.Rowe Price and Wells Capital. Combined, all three
companies own over 7.2% of Hatteras’ shares. That works out to over 7.1 million shares that are
worth more than $191 million based on today’s share price.
It is no surprise that large institutions
are holding mREITs like Hatteras.
Currently, Hatteras pays a dividend
of $2.80 per year for a dividend yield
of 10.40%.
Hatteras’ Cash Flow to Net Income Ratio is on a
Healthy Upswing
1.30
1.25
1.20
BlackRock alone collects more than
$15 million a year in dividends as the
company’s second largest shareholder.
1.10
1.05
10
FY2012
FY2011
FY2010
FY2009
1.00
FY2008
As you can see in the accompanying
chart, the company’s cash flow to net
income ratio has increased since it
began operations. This is a good sign
for a dividend payer.
1.15
Oxford Income Letter Special Report: Spread Trusts: How to Double Your Money...
An increase in the cash flow to net income indicates the company’s cash flow is in good health
and that future dividend obligations will be paid.
We believe now is a great time to pick up shares of Hatteras. The company trades at a P/E ratio of just
7.35. This is well below the industry average of 14, signaling an attractive buying opportunity.
Even if share prices stay flat, you should feel comfortable earning a double-digit dividend yield
that could move much higher once the bond bubble bursts.
Action to Take: Buy Hatteras Financial Corporation (NYSE: HTS) at market. And use our
customary 25% trailing stop to protect your principal and your profits.
Spread Trust #3: Capstead Mortgage Corporation (NYSE: CMO)
Our final Spread Trust has been in business since Ronald Reagan was in the White House.
Headquartered in Dallas, Texas, Capstead is a self-managed mREIT.
Its management has 80 years of combined industry experience, making it the most experienced
mREIT in this report. And although it is the smallest company of the three, with a market cap
of $1.18 billion, it still carries plenty of clout.
And there’s nothing small about its dividend. Capstead’s annual dividend is $1.20, which works
out to a 9.8% dividend yield at current prices. And speaking of current prices… Capstead sells
for less than half the share price of the previous two mREITs.
You Might Be Familiar With This Business Model
Just like American Capital and Hatteras, Capstead invests in a leveraged portfolio of residential
mortgages that are guaranteed by the government.
All of the securities it holds are issued and guaranteed by Freddie Mac, Fannie Mae or Ginnie
Mae.
A majority of the company’s investments are in adjustable-rate mortgages, which allows it to reset
to more current rates in a shorter period of time. And its mortgage investments are highly liquid
and can be financed through repos with multiple providers.
This is good news for our Treasury bubble play.
With its high exposure to adjustable-rates, Capstead could see the spread on a majority of its
mortgage portfolio expand faster than most mREITs.
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Oxford Income Letter Special Report: Spread Trusts: How to Double Your Money...
You see, with adjustable-rate mortgages, when rates rise, the cost of the loans adjust higher. This
means more money for the lenders and owners of those assets.
A faster increase in the spread can be achieved with adjustable rates, which could produce quicker
profits for Capstead and put more cash in investors’ pockets. Once again, 90% of the mREITs
taxable income goes directly to shareholders.
Producing a Top Return for Shareholders
Capstead’s management has consistently produced a return-on-equity (ROE) that beats the
industry’s average of 11.8%.
In the chart to the right, you can see
that in the last two years, Capstead
has produced an average ROE of
12.90%.
Capstead’s Return-on-Equity is One of the
Industry’s Best
14%
13%
It’s no surprise that mREIT analyst
Michael Widner of Keefe, Bruyette &
Woods rates Capstead in the “sector
outperform” category.
12%
11%
10%
Q4 2012
Q3 2012
Q2 2012
Q1 2012
Q4 2011
9%
Q3 2011
Q2 2011
Q1 2011
And once again, large institutional
players like Vanguard, BlackRock and
J.P. Morgan are loaded up on shares.
Combined, they have a 13.42%
ownership in Capstead worth more than $163 million.
We are not shocked that mutual fund companies and investment banks hold mREITs like Capstead.
Agency-guaranteed mortgages have little, if any, credit risk. As long as the federal government supports
Fannie Mae and Freddie Mac, it is also supporting the bulk of Capstead’s portfolio.
With money being made from the spread between short-term borrowing and long-term
mortgage loans, Capstead is another mREIT that could see profits take off when the bond
bubble reaches its tipping-point.
And in the meantime, we collect a 9.8% dividend yield while we wait.
Action to Take: Buy Capstead Mortgage Corporation (NYSE: CMO) at market. And use our
customary 25% trailing stop to protect your principal and your profits.
12
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