#$nly

It’s not how much you make that ultimately matters in wealth accumulation but how much you keep, and the amount of your gains that get lost to taxes are a major factor in your realized returns. 

Thankfully, you don’t have to be a millionaire with an army of lawyers to effective game the tax code. Even the basic tools available to every American taxpayer, such as IRAs and Roth IRAs, can be wildly effective in lowering your tax burden and compounding your wealth at a much faster rate. 

But as wonderful as an IRA or Roth IRA can be as a tax-free accumulation vehicle, we’re limited to contributions of just $5,500 per person per year ($6,500 if you are aged 50 or older). And worse, your ability to contribute to a Roth IRA gets phased out at higher income levels. So, if you’re aggressively saving for retirement, you’re going to have a large portion of your savings invested outside of an IRA or Roth IRA and subject to ravages of taxation. 

This means we have to pick and choose which investments we put in our IRA or Roth IRA. And choosing poorly here can make a big difference to the lifestyle you can afford in retirement.

What Not to Buy in an IRA

Let’s start with what you shouldn’t put in an IRA or Roth IRA. Most obviously, this would include tax-free securities like municipal bonds. Any investor stupid enough to waste precious IRA funds on tax-free muni bonds should be taken out back and shot. Or at least sterilized. 

The same is true of MLPs and other “special” stocks that create tax complications. Because MLPs can generate unrelated business taxable income (“UBTI”), they can create bizarre tax situations in which your IRA has to file its own tax return and pay taxes. And looking at the bigger picture, given that most MLP distributions are indefinitely tax deferred, there is no benefit to placing them in an IRA or Roth IRA. You're effectively wasting precious IRA dollars. 

Casting the net a little wider, I would say the same about tax-efficient index mutual funds or ETFs you intend to hold for the long-term. There’s just no point in putting them in an IRA. Portfolio turnover is minimal in index funds, so they generate very little in taxable income other than the dividend yield, which these days amounts to all of 2%. Plus, once you sell the funds to pay for your retirement expenses, you’re going to be paying ordinary income tax rates on the full amount of the funds withdrawn from an IRA, whereas you’d be paying the long-term capital gains tax rate on just your capital gains on a taxable mutual fund or ETF investment. (You wouldn’t pay taxes on monies withdrawn from a Roth IRA, but my point stands.) 

Now that we’ve gotten that out of the way, we can talk about what makes a solid IRA investment. Ideally, you should prioritize for your IRA or Roth IRA any investment that gets a large chunk of its total return from current income. And specifically, it should be current income that does not benefit from special tax rates, such as qualified dividends taxed at the preferential 15% and 20% rates.

So with no more ado, let’s jump into the five best IRA investments.

Business Development Companies

Business development companies ("BDCs") are an interesting niche of the market. They essentially do what banks used to do back in the good ol’ days before the 2008 crisis: Lend money to up-and-coming businesses. 

The tax code gives a nice bonus to BDCs. In order to encourage them to provide funds to capital-starved young businesses, all profit is tax free at the corporate level…so long as they distribute at least 90% of it as dividends. 

As BDCs are unable to retain much of their earnings for future growth, a large chunk of the total returns to investors comes from the dividend. Many BDCs yield well in excess of 10%. 

That alone would make them an ideal IRA investment. But that’s not where the story ends. The taxability of BDC dividends will vary from company to company, but the dividend will generally be some combination of lower-taxed “qualified” dividends, higher-taxed unqualified dividends and tax-deferred return of capital. Typically, the biggest chunk of the dividend is considered non-qualified and taxed as ordinary income, making BDCs woefully tax inefficient. This makes them particularly well suited for an IRA or Roth Ira. 

I’m a fan of BDCs under the right conditions, and I made a BDC my pick in this year’s Best Stocks contest. Prospect Capital (PSEC) trades at a deep discount to book value and pays a fantastic 14% dividend yield.  Thus far, the stock has had a rough 2015, though I expect it to finish the year strongly. I also consider it an outstanding IRA investment…and happen to own it in my own IRA.

Equity Real Estate Investment Trusts

Along the same lines we have equity REITs. Equity REITs have one of the simplest business models out there. They buy or develop real estate, lease it out, and collect the rent. As with BDCs, REITs pay no taxes at the entity level…so long as they pay out 90% of their net income in the form of dividends. 

Though REITs are considered to be long-term growth vehicles, they also get a high percentage of their total return as income. But as far as tax treatment goes, REITs tend to get punished even harder than BDCs. In any given year, some portion of a REITs dividend may be classified as capital gains distribution or as a tax-free return of capital. But the lion’s share of the payout will generally be a non-qualified dividend taxed as ordinary income. 

One REIT I hold in my IRA that I am unlikely ever to sell is “the monthly dividend company” Realty Income (O). Realty Income has paid 540 consecutive monthly dividends and has increased its dividend for 71 consecutive quarters. At current prices, it yields about 5%.

Mortgage Real Estate Investment Trusts

Even less tax efficient than equity REITs would be their cousins, mortgage REITs. 

Like equity REITs mortgage REITs avoid taxation at the company level so long as they distribute 90% of their profits as dividends. But mortgage REITs are even more dependent on their dividends for their total returns than equity REITs, as there is virtually no long-term growth component. 

Equity REITs hold properties that are presumed to rise in value over time. Mortgage REITs hold mortgages…which are eventually paid off or refinanced. Many mortgage REITs, including blue chips like Annaly Capital (NLY), pay dividends well in excess of 10%. And virtually all of it is going to be taxed as regular income. This makes a mortgage REIT a very obvious choice as an IRA investment. 

Mortgage REITs have been slammed in 2015 by fears that a Fed rate hike would raise borrowing costs and crimp profitability, and today many mortgage REITs trade for just 80%-90% of book value. At these prices, they would seem to be a low-risk bargain.

Bonds

Personally, I think you would have to be crazy to own bonds at today’s yields. I am about as close to a “bond bull” as you are likely to find these days because I believe that long-term yields will stay low for a long time to come. But that is hardly a rousing endorsement. 

At current yields, you’re locking in returns of, at best, 2.2% in 10-year Treasuries, and high-quality corporate bonds don’t yield much better. In my view, you’re much better off trying your luck with high-quality dividend-paying stocks. 

Nevertheless, some investors crave the safety and predictability of bonds. And if you are going to invest in bonds, then by all means, you should protect your modest income stream by placing them in an IRA. Bond interest is taxed as ordinary income, and bonds get virtually all of their returns in the form of current income if held to maturity. This makes them an extraordinarily tax inefficient investment…and a perfect IRA investment.

Precious Metals 

And finally, we get to precious metals. I don't consider previous metals an "investment," per se. In my view, you keep a few gold coins around for the same reason you keep a gun: As "insurance" in the event that things really got bad. (Yes, my true Texas colors are starting to come out.) 

So, I personally would never keep a position in gold or any other precious metal in an IRA. In the event I actually needed gold, I would want it physically in hand. But I also realize that my views a little eccentric here. Plenty of investors consider precious metals a viable asset class and allocate a portion of their portfolio to it in the form of a metal-backed ETF such as the SPDR Gold Trust (GLD) or the iShares Silver Trust (SLV). 

If you are one of those investors, keep your precious metals investment in an IRA. Metals are considered “collectibles” for tax purposes, and gains are taxed at a 28% tax rate rather than the usual 20% capital gains rate.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog. 

As a value investor, I’m a little frustrated these days. There is virtually nothing cheap anywhere in the public markets. Stocks are expensive, trading at cyclically-adjusted price earnings ratios higher than those before the 1929 and 2008 crashes. And the 10-year Treasury yield — even after its recent surge — is barely 0.4% above the core inflation rate.

Yet there is one corner of the market still showing signs of value: mortgage REITs.

I wrote earlier this year that mortgage REITs as an asset class were trading at some of the steepest discounts to book value in history. Well, as we round out the first quarter, very little has changed on that front. Even as earnings and revised book values have come in, valuations haven’t changed much. 

Consider the chart above, which details the top ten holdings of the iShares Mortgage Real Estate Capped (REM). The mortgage REIT universe is small, and the top ten holdings make up 68% of the total portfolio. Two mortgage REITs alone — Annaly Capital (NLY) and American Capital Agency (AGNC)— make up about 30% of the portfolio. 

We see a common theme throughout the top ten holdings. This is one of the few remaining truly high yield corners of the market, and the top ten holdings have a weighted average yield of 10.4%. 

But what interests me more are the large discounts to book value. The top ten holdings trade for 97 cents on the dollar. But Annaly and American Capital Agency trade at even deeper discounts, 81 cents and 83 cents on the dollar, respectively. 

Let me put this into perspective. You could hypothetically buy up all of the shares and close the two mortgage REITs, selling their assets as spare parts, and still make a respectable profit of 19% and 17%, respectively. 

The market seems to be pricing in major capital destruction by their respective managements. But is that fair? Annaly in particular has a long operating history, and it has survived every conceivable bend and twist in the yield curve over the years. Granted, our situation today — one in which short-term rates are at zero and mortgage rates near all-time lows — is unprecedented. But at these discounts to book value, the market is practically gift wrapping a massive margin of safety for us. 

Let’s take a look at Annaly’s historical price/book ratio to get a little perspective.

For virtually its entire history as a publically-traded mortgage REIT, Annaly has traded at a significant premium to book value. This makes perfect sense. Annaly can borrow much cheaper than you or I could and has economies of scale that we don’t. Investors pay for that in the form a premium to book value.

But something strange happened in early 2012. The price fell below book value, where it has stayed ever since. Investors feared that a flat yield curve and falling mortgage rates would crimp profitability and force Annaly to cut its dividend. And this has indeed proven to be the case. Annaly cut its dividend twice in 2012 and twice again in 2013. But at current prices, Annaly and its peers have been more than adequately punished for their dividend cuts, come what may with Fed policy and mortgage rates. 

In late January, I suggested that mortgage REITs should aggressively repurchase their shares. Rather than buy low-yielding mortgages — or slide down the credit quality scale to chase yield — mortgage REITs trading at discounts to book value should absolutely repurchase their own shares. It’s the only sensible thing to do. 

If Annaly — and the rest of the mortgage REITs trading at deep discounts to book value — care about the best interests of their shareholders, they will aggressively buy up their own shares on the open market as their portfolios of mortgage securities roll off. 

If you don’t buy your own stock at 80 cents on the dollar, then when would you? 

Disclosures: Long NLY, REM 

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

As I wrote recently, mortgage REITs as a sector are trading at some of the steepest discounts to book value in their histories. I consider mortgage REITs trading at eighty to ninety cents on the dollar to be a fantastic bargain. But I also know that those bargains exist for a reason. With bond yields--and mortgage rates--scraping along near all-time lows and the Fed expected to at least modestly raise rates this year, the fear is that the interest rate spreads that allow mortgage REITs to pay out such large dividends are about to get crimped...and force the mortgage REITs to slash their dividends. When mortgage REITs' higher-yielding mortgages get prepayed by homeowners, the mortgage REITs are left with slim picking to reinvest in today's market.

It's a problem with an easy solution. Rather than buy low-yielding mortgages--or slide down the credit quality scale to chase yield--mortgage REITs trading at discounts to book value should repurchase their own shares. In fact, I'd argue it's the only sensible solution at current prices.

Mortgage REITs haven't been very active on the share repurchase front. Annaly approved a share repurchase program in 2012, but it didn't amount to a lot. Looking at Annaly Capital's (NLY) history (see chart above), the REIT has been a lot more aggressive in issuing new shares. That made sense when interest rate spreads were wide and the high yields were there for the taking. But it certainly makes no sense at today's prices. And to Annaly's credit, they've moderated the new share issues of late.

Frankly, if Annaly--and the rest of the mortgage REITs trading at deep discounts to book value--care about the best interests of their shareholders, they will step up the share repurchases as their portfolios of mortgage securities roll off. If you don't buy your own stock at 80 cents on the dollar, then when would you?

In October, I wrote that mortgage REIT dividends had stabilized and that many were trading below book value. As we enter 2015 much the same way we entered 2014--with fears of rising rates and an overheated stock market--I wanted to revisit the table I prepared in my October comprehensive portfolio review.

Mortgage REITs are not quite the value they were this time last year or even as recently as October. Taking a simple average of the mortgage REITs in the table--which represent the top ten portfolio holdings of the Market Vectors Mortgage REIT Income ETF (MORT)--we see the sector trading at book value and yielding 10.0%. Still, even trading at book value, mortgage REITs are far from expensive. M-REITs generally trade at a significant premium to book value (see chart). Many of these m-REITs have short trading histories, but Annaly Capital (NLY), the granddaddy of the sector and the largest by market cap, has spent virtually the entire period from 2000 to 2013 well above book value.

Dividend cuts are a distinct possibility. But worrying about those today is a case of closing the barn door after the horse has already bolted. Annaly cut its dividend in June and September of 2013 but kept it steady last year. American Capital Agency (AGNC) cut its dividend aggressively in October of last year. Two Harbors Investment Corp (TWO) modestly cut its dividend last year. Bucking the trend, Starwood Property Trust (STWD) actually raised its dividend in 2014.

Could further dividend cuts be on the way in 2015? Sure. It's a real possibility, particularly if the Fed follows through with raising short-term rates. But with yields averaging 10.0%, we have quite a bit of wiggle room.

I expect to see mortgage REITs deliver something along the lines of 20% total returns (capital gains + dividends) this year. Let's say I'm overly optimistic and the returns end up being closer to 10%. That's still better than what I expect the U.S. market to deliver given current valuations. U.S. stocks trade at 27 times cyclically-adjusted earnings, making them 63.9% higher than their long-term average and implying annual returns over the next eight years of just 0.3%. Given the choice between overpriced U.S. stocks and modestly undervalued m-REITs, I'll choose m-REITs.

The same logic applies to business development companies ("BDCs").  Let's look at the largest holdings of the UBS ETRACS Wells Fargo Business Development Company ETN (BDCS).

Taking a simple average, the top BDC holdings sport a dividend yield of 8.7.% and trade slightly below book value. But as was the case with mortgage REITs, BDCs often trade at a significant premium to book value. BDC valuations fell off a cliff during the 2008 meltdown before recovering into 2010. But the overall trend in price/book valuation has been down. As a group, this is the cheapest the BDC sector has been since the crisis.

Can cheap sectors get cheaper? Of course. But given the alternatives in a broadly overpriced market, I'll gladly take the 8.7% dividends on offer from BDCs.