Here’s the math
In his interview at the Sohn Investment Conference, Jeffrey Gundlach shared his thoughts on how you could earn a 35% return through an income arbitrage involving buying mortgage REITs (REM) and shorting utilities (XLU).
Since the middle of 2003, utilities are up like 40%, while mortgage REITs are slightly negative over their 2003 value. So, the valuations are incredibly stretched, according to Gundlach. So, if you own REITs, you get a yield of more than 11%. If you own utilities, you get a 3% return. So, you have an 8% positive income arbitrage right there!
Lever it once and you’ll get 15%. He also sees the two (mortgage REITs and utility) prices converging (their price to earnings and book value ratios) by at least 10%. So, you get a minimum of a 35% return in a year or so.
Mortgage REIT funds
Gundlach also discussed commodities—oil and gold.
On the commodity side, Gundlach thinks that oil made it easily to $40 per barrel. It might have a hard time reaching $45 per barrel. If it goes back down to $38, it might be a concern.
Gundlach also liked gold. “Gold is doing fine. It’s preserving capital in the US, it’s been making money over the last couple of years for European investors. That’s why I own gold. Because in a negative return environment anything that holds its value or makes a little is good,” said Gundlach at the conference.