In its third round of quantitative easing, the Federal Reserve will be buying at least $40 billion worth of mortgage-backed securities a month with no end in sight for those purchases. Their action decreases the risk of mortgage securities since we know there will be constant demand from the Fed.

This buying is coming at a time when distressed mortgages are looking a little less distressed. Home prices may have finally found a bottom, according to some experts, and that is helping homeowners. Traders can benefit from these trends by buying a company that is active in this distressed mortgage market.#-ad_banner-#

Distressed mortgages include loans that are being paid late or are underwater, meaning the homeowner owes more on the mortgage than the home is worth. These borrowers might default or try to work with their lender to sell the house at market value and have the lender write off the debt. A home with a mortgage like this will often sell at a discount to its neighbors because lenders want a quick sale and homeowners generally just want to move on. Buyers of these homes have been able to profit and there are even some hedge funds looking at how to get into this market.

Recent news reports estimate that the number of underwater mortgages is declining, but there are still about 10.8 million American households facing this problem. That represents about 22.3% of all outstanding mortgages. Despite negative equity, most homeowners (about 85%) in this situation are still paying their mortgages on time. These mortgages are profitable to the lender, and a continuing real estate recovery could increase profits in the mortgage market.

There is one publicly traded company that offers traders a way to profit in this segment and pays a dividend of almost 10%, allowing traders to consider this as much an income trade as it is an equity trade.

PennyMac Mortgage Investment Trust (NYSE: PMT) invests in mortgage loans, “a substantial portion of which may be distressed and acquired at discounts to their unpaid principal balances,” according to the company. The company will use loan modification programs and other initiatives to try to keep borrowers in their homes and paying on the loans. An improving economy should help their efforts.

PMT is a real estate investment trust (REIT) and will pay out almost all of its earnings as dividends. That explains the company’s high yield of 9.8%. Seven Wall Street analysts cover the company and all seem to believe that it offers a low-risk, high-income investment. Earnings growth is expected to average 25% a year for the next five years, and dividend growth should be close to that given the company’s REIT structure.

These factors make PMT a buy. The stock is among the strongest in the market, with a relative strength rank of 98, meaning that PMT has outperformed 98% of investment alternatives during the past six months. The stochastics indicator is also on a buy signal. 

The price target of $26.26 a share is about 13% above the current price of PMT. If the stock hits the price target within a year, the 9.9% dividend provides a total return of almost 24% on the trade.

Some traders may think this is a low rate of return on a trade, but high-dividend stocks can be bought on margin and that will increase the rate of return. Interest rates on margin loans can be substantial (about 7%-8% for accounts under $25,000), but PMT offers a dividend that covers the cost of that loan. With full margin, the trade could deliver a 30% gain in one year. This kind of a trade can be useful in a high-risk stock market to provide steady returns and offset potential risks.

You can generate even more income by selling covered calls against PMT. With this trade, you buy the stock and sell a call for every 100 shares you purchased. This limits your potential gains to the difference between the options strike price and the price at which you buy PMT plus the options premium.

At-the-money January 2013 calls with a strike price of $25 are selling for about 30 cents. If that option is called, you would receive one dividend payment plus the option premium and realize a gain of about 11%, an annualized return of about 45% on the position (assuming PMT is eventually called at $25). If it is not called, you could continue selling calls indefinitely to boost your income.

This is a great play for anyone thinking the market could pull back in the short term. It is an income trade with low volatility and could be thought of as a safe port in a storm if market turbulence develops.

Action to Take –> Buy PMT at the market price. Set stop-loss at $21. Set initial price target at $26.26 for a potential total return (including dividend) of 24% in 12 months.

Buy PMT at the market price and sell PMT Jan 25 Calls for $0.30 or more. Do not use a stop-loss. If the option is not exercised, sell an April at-the-money call. If the trade can be repeated four times over 12 months, the potential gain would be 45%