BTO - The More You Sell The More I Buy

2023-03-27 14:00:00 ET

Summary

• Lately, the market has been driven more by fear and less by greed.
• For every buyer, there must be someone or something, who is selling their shares.
• I buy for very different reasons than others, but my reasons provide a rich and bountiful retirement outlook.

Co-produced with Treading Softly

When you buy something, someone has to be selling it. It seems like a "duh" statement, yet we often take this for granted in our day-to-day life.

Consider the following scenario - I walk into Target, buy a bottle of Coke and walk out. I don't consider that Target is actively selling this to me, I just think about how I'm buying it.

In the stock market, this axiom is still very much in action. For you to have shares to buy, someone or something has to be selling them to you. It might be a fellow investor, a company, or a fund. Your shares may be newly minted from the company or fund that is issuing them to the market, or your shares may have traded hands countless times as they've been in existence for decades. This can be especially true for large companies that are no longer issuing new shares but are still actively traded in the market.

As an income-focused investor looking to buy income-producing investments and hold them for years to come, I find myself buying up what others are unwilling to keep. Investors in the flea market of stocks are often racing towards what is popular right this second, and selling off stocks that will be great long-term investments. These are typically caused by strong shifts in market sentiment, creating what I like to call "accidental high yielders"

So, as the title says, these two picks are ones that the more others sell, the more I keep on buying.

Let's dive in!

Pick #1: AGNC - Yield 14.7%

The trouble with Silicon Valley Bank's balance sheet stemmed from unrealized losses in its "held to maturity" portfolio. The bulk of those losses stemmed from agency MBS. Source

The benefit of agency MBS is that it is guaranteed by the agencies Fannie Mae and Freddie Mac. At maturity, the MBS holder will receive par value. For this reason, any securities that banks identify as "hold to maturity" can be carried at their amortized cost basis instead of being carried at fair value. After all, if held until maturity, you know that the MBS will pay you $100. The fact that it is trading for $83 today is irrelevant if you are planning on holding to maturity.

Of course, if there is an unexpected need for cash, like billionaires and millionaires wiring all of their funds to other banks... suddenly those assets that were supposed to be held to maturity need to be dumped into the market at firesale prices.

This is why, if you told me that the SVB failure was, in fact, a "Lehman moment," and there would be widespread issues at banks around the country, mortgage REITs like AGNC Investment Corp. ( AGNC ) would be at the top of my buy list.

Yes, AGNC owns agency MBS. It was the decline in the price of agency MBS that drove AGNC's book value down over the past year. Source

Unlike SIVB, AGNC reports the fair market value of its MBS portfolio every quarter. So investors saw every painful step-down each quarter. While investors in SIVB were blissfully unaware that tangible book value after accounting for the fair value of their portfolio had fallen to $14.40, as opposed to the $275.38/share when accounting for the hold-to-maturity portfolio at cost basis.

Why would anyone want to invest in agency MBS when it just caused such a catastrophe at SVIB? Because it is cheap and unlike SVIB, AGNC has the luxury of holding to maturity. AGNC owns $60.66 billion in agency MBS by par value. It is carrying them at a $57.743 billion fair value.

That is $2.917 billion, or $5.12/share, difference between the market value and par value. These MBS will be paid back at par. In the meantime, AGNC is collecting an average coupon of 4.13%.

Now, AGNC does leverage its MBS investments using repurchase agreements and also hedges against interest rates using interest rate swaps and short positions on U.S. Treasuries. To protect itself from any cash needs necessary to maintain its investment positions, AGNC has $4.7 billion in unencumbered cash and assets, representing approximately 60% of tangible book value.

In short, AGNC can sit and hold until maturity and only needs to sell if it wants to. This is usually done when it believes that swapping to a different coupon or maturity results in a better return.

Why do we say that a banking crisis is great for AGNC? Here is a look at MBS prices over the past month. We look at the 4.5% coupon since that is AGNC's largest position, but other coupons reacted similarly: Source

Note that the price was declining for the past month since earnings were last reported. Then on Friday, March 10th, with the news of SIVB failing, MBS prices surged, recovering most of the declines over the past month in a single day.

Prices were falling because the MBS market was responding to the growing belief that the Federal Reserve would hike rates by 50 bps in March. Banks being pushed into failure is something that has many believing the Fed will maintain a slower pace. One bank failure might not be enough to convince the Fed to pivot, but multiple bank failures certainly would be.

So we aren't going to count on the reversal in MBS prices that Friday to stick. As the market calms down, perhaps the downward pressure returns. Looking at the bigger picture, MBS prices have stabilized significantly from their October 2022 lows.

The surge in prices on the 10th demonstrates that Agency MBS is still a "safe-haven" investment. When the markets crash, banks fail, and recession strikes, MBS prices go up - AGNC can afford to sit and wait for that to happen. In the meantime, we can collect a hefty double-digit dividend and own a company that should do well if a recession strikes.

Pick #2: BTO - Yield 8.8%

John Hancock Financial Opportunities Fund ( BTO ) is a closed-end fund ('CEF') that invests in banks. In BTO 's annual report , we counted 118 common equity investments in banks.

Do you know which banks were not in BTO? Silvergate Capital ( SI ) and SVB Financial Group ( SIVB ) were both absent as of December 31st, 2022, and from their latest monthly report. BTO didn't hold these banks three months ago, and they didn't hold them last month.

This is one of the reasons we invest in CEFs. With a closed-end fund, you can let a trusted manager make decisions in a sector that you might not follow closely. At HDO, we cover hundreds of dividend-paying stocks, but we don't read the SEC filings of 118 banks. Banks typically don't pay a yield that meets our goals, so our research time is devoted elsewhere. For banks, we placed our trust in BTO management to identify opportunities and avoid landmines.

So when the news was breaking about SIVB's bank failing and banks were crashing, we checked BTO's holdings. Management did their job and avoided a $0. There was something that management simply didn't like about SIVB, and it chose not to purchase it over any of the 100+ other banks it invests in.

BTO utilizes a modest level of leverage, currently borrowing about $125 million, or 17% of assets. $65 million of that is hedged through interest rate swaps through 2030. Source

As a result, BTO pays an effective interest rate of 1.13% on $65 million. The other $60 million will be at 1-month LIBOR plus 0.6%. So if LIBOR went up to say 6%, BTO would pay 6.6% on $60 million and 1.13% on $65 million. On its total borrowing, BTO would be paying a 3.75% effective yield. The impact of rising rates on borrowing costs has been significantly reduced, allowing BTO to remain leveraged with comfort.

Banks sold off heavily on Friday, March 10th, and BTO was down 5.6% (plus another 2% because it was ex-div). As I outlined to our subscribers, I do not see that what happened at SI and SIVB as a systematic risk throughout the banking sector. On average, banks are very strong and are in a far superior financial position than they were during the GFC.

The reality is that when you are dealing with "averages," there will be some holdings that are below average. Even when a sector is strong, there will always be some outliers that will fail. We are encouraged that BTO avoided two banks that turned out to be much weaker than average. While others are dumping all the good banks, we are happy to increase our exposure to the sector through BTO.

Conclusion

With AGNC and BTO, I can benefit from the fear and panic of others to see my income grow rapidly. The more others sell in panic, the more my income grows through buying.

Our unique Income Method approaches the market from a value investing and contrarian outlook, where often we are on the other side of a transaction with a momentum or day trader looking to do a quick exit.

Why do we espouse those views? It allows us to enjoy strong income from a portfolio yielding over 9%. We don't have to worry about the day-to-day swings in the market because our gains come through dividends - not by trying to find someone willing to pay a higher price.

Let's talk about a different kind of swing - my golf swing. The key, I'm told, is not just in the swing itself but in your stance beforehand and in your follow-through after hitting the ball. A proper stance allows you to line up your shot correctly, and the follow-through ensures your swing is smooth and fluid.

Similarly, the investments in my portfolio are selected in such a way that it generates income. In order to do so, my stance when looking at the market is oriented towards investments that pay a high dividend, and my follow-through allows me to ignore the trader-focused noise and collect large dividends - all while I work on my golf swing in real life.

How many of us can say we don't need to look at the market on a daily basis? What about a weekly or monthly one? I know many income investors who rarely look at their portfolio other than to tap into dividends for their retirement spending, all because they have a portfolio they can rely on to do what it's made to do.

That's what I want for you, and that's what our Income Method can provide!

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