A Few Reasons to Consider Annaly Capital

Mortgage Ap Feature

In this article I will discuss Annaly Capital Management (NYSE:NLY) and why I believe that things are turning around for the company. Prior to providing the evidence I will share with you how the company operates.

For those unfamiliar with the company, Annaly is a mortgage real estate investment trust (mREIT). It’s not that hard to understand how Annaly or most other mREITs operate. First and foremost, the companies often borrow and lend mortgage-backed securities (MBSs). What are MBSs? MBSs are essentially debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property.

Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization. Now, what feeds into their profits? The interest rate that Annaly borrows at and the interest rate they lend at is called the spread. This metric is absolutely key and is one that you must assess when choosing an mREIT. So where does Annaly make its money? Well, yes, from the spread, but how specifically?

Generally, Annaly has a pretty conservative business model and tends to borrow between the two-year Treasury and lend to the 10-year Treasury. So basically the firm borrows at a lower-cost item and lends at a higher rate, generating a spread and pocketing the difference. Then there is leverage, which allows potential profits to be magnified. This is when Annaly lends further out on the curve — maybe to 15, 20, or even 30 years. This leverage is risky but can lead to huge profits. Although it leverages, Annaly being somewhat conservative tends to have a lower amount of leverage than most mREITs.

How can Annaly make more profits or lose money?

There are very basic things you need to be aware of. Forget about taper/no taper madness. What you do care about with the Fed is that it has a zero interest rate policy in place. This keeps shorter-term interest rates between 0 and 0.3 percent, so Annaly will always be able to borrow cheap money. This has been key to maintaining a favorable spread. Pressuring the spread has been Fed purchase programs, which can keep the longer-term interest rates low as Annaly purchases longer-term Treasuries. Anything that changes the yield curve between the two-year and 10-year or 10- and 30-year rates can cause either widening or flattening of the spread.

We saw a spike in interest rates in shorter-term debt from May to August, which put massive pressure on the mREITs. Many of the spreads narrowed. This led to these stocks getting crushed. Sometimes the rates can be higher on shorter-term debt than on longer term debt. This is a dangerous situation for Annaly. The Annaly option is proper hedging of the portfolio, rebalancing the portfolio rapidly, and/or taking on more risk. If it does not, Annaly will suffer losses. As such, the company reduced leverage in the summer and fall of 2013, rebalanced the portfolio, and took heavy realized losses. This led to dividend cuts and reduced share price. However, I think the worst is now over and that Annaly is a good buy at current levels.

Another dividend cut could hurt, but the worst is likely over

Annaly can handle higher rates, but it is the pace of the increases we need to be concerned with. Last month, Annaly’s dividend announcement revealed yet another cut to 30 cents down from the Q3 2013 dividend of 35 cents. We know that Annaly has to pay 90 percent of its taxable income to shareholders, but the company generally gives us GAAP earnings. Taxable and GAAP earnings will typically differ due to items such as unrealized and realized gains and losses, differences in premium amortization and discount accretion, and non-deductible general and administrative expenses. This makes it hard to predict where the dividend is going. What 2014 will bring is tough to predict accurately, but I think most of the cuts are over. There could be a Q1 2014 cut to the dividend down to 27 cents-28 cents per share, but I think we are more likely to see the dividend be maintained at 30 cents. Another cut could be a catalyst that sends shares below the $9.75 support line.

However, should the company maintain or even raise its dividend, the stock could rise, as this would be viewed as a positive catalyst. While maintaining the dividend may be perceived by some as difficult to pull off, the company’s diversification is starting to pay off. We will get more clarity after the Q4 2013 report, but the acquisition of CreXus was wise in my opinion. Another bloodbath quarter is unlikely. This is because the company has reduced leverage and increased its hedging activities. While this cuts off upside potential for its earnings, the downside is now severely limited. All in all, I think the risk is starting to look to the upside for this stock.

Funds from operations

Annaly is a good buy at these levels because its funds from operations are improving. At the current share price of $10, assuming the 30 cent dividend is maintained in Q1 2014, it will pay $1.20 annually, or 12 percent. How about Annaly’s most recent funds from operations? Annaly’s most recent funds from operations were a big improvement quarter over quarter. While many viewed the third quarter as weak, it was strong in this regard. In Q2 2013, the company reported funds from operations of -$3.9 billion, a major loss, but rebounded to roughly $795 million in the most recent quarter, snapping three straight quarters of decline and losses. I am confident that another positive quarter will be delivered, and if funds from operations can exceed the Q3 number, it will send shares higher.

Dividends fluctuate but continue to be paid

Annaly has been paying a strong dividend since the late 1990s. Many have asked me for advice bought in and held strong since 2010 or 2011, when these stocks were first widely being recommended. You need to remember why you bought Annaly, and that reason is primarily to collect the dividend. To see where some of these buys might be, with a worst case scenario analysis, Table 1 shows how much an Annaly investor would be down who got in during December 2009.

Table 1. Annaly Capital Management’s common stock dividend history — dividends paid since 2010.

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As you can clearly see, Annaly has paid bountiful dividends for the last three years. The dividend now being at 30 cents is obviously at the lowest it has been in the past four years, and it wasn’t this low since fall 2007, when the dividend was 26 cents (data not shown). What this illustration is going to show is the strength of holding a high dividend payer through all the ups and downs.

Let’s take the example of a poor soul who bought in at the highest possible price, during December 2009. Let’s assume that person purchased shares once, not adding to declines or reinvesting any dividends. This buyer with awful timing would have acquired shares then at $18.80 per share on December 14, 2009. Thus, as of the current price of $10.20, this person would be down $8.60 or 45.7 percent. That is some real pain right there. It’s just a real disappointment over five years.

But what if we factor in those dividends? The dividends paid — not counting the 30 cents to be paid in January — total $9.09. Therefore, the most unlucky buyer in December 2009 is actually up 49 cents per share, or 2.5 percent, and will be about completely even should the share price hold current levels until the dividend is paid out in January. Should the shares hold around this price or go up, all future dividends are gains. When the shares rebound, real gains are had, solely because of the dividends. Everyone who bought in prior to this and collected earlier dividends is likely up nicely. This example isn’t all that fair, because most buyers should build a position on the way down, especially for a long-term holding, as I always recommend to do.

So yes, the short-term pain is real. The disappointment of a lower share price from where you may have bought and being paid less to wait for a rebound is not easy to stomach. But look at it objectively. Yes, if you bought in the last two years, you are down. It could take several more quarters to break even. You could take a loss and invest elsewhere. However, you are likely to miss out on the coming rebound in prices. Should there not be a rebound, you can simply collect the dividend as cash while waiting for the rebound, or even reinvest those dividends and build a large position while the shares trade so low. When the rebound comes, a nice capital gain can be had.

Please note that this does not count any taxable events. Furthermore, I only recommend holding mREITs in tax-favored accounts such as an IRA or ESA.