When The Fed Stops Buying These mREITs Could Be Flying

| About: Annaly Capital (NLY)

The never ending story surrounding Federal Reserves policies is a constant reminder to every investor that at some point the financial markets will change. I suppose the big question for investors is where to put money to work when that happens. I believe that when the Fed stops buying MBSs and longer term Treasuries, the agency backed mREIT sector will really start flying. Specifically, Annaly Capital (NYSE:NLY) and American Capital (AGNC), the two "best of breed" companies in the entire sector.

To understand my thesis, let me review the Fed policies now, as well as what the mREIT sector might look like when (and if) the policies change.

To encapsulate the Fed's policies, let me briefly outline them:

  • The Fed has a zero interest rate policy (ZIRP) that has kept short term Treasury yields (2 year terms) near zero (.25%).
  • The Fed spends $85 billion every month buying mortgage backed securities and longer term Treasuries.
  • In an effort to push mortgage rates lower, stimulate the housing recovery, stimulate bank borrowing and lending, stimulate an economic recovery, and help improve corporate profits which could stimulate job growth, the Fed has repeatedly stated that this policy would remain in effect until the unemployment rates drops below 6.5% and inflation stays under 2.5%. (Whew, that was a long sentence!)

Many folks, mainly investors who might have missed this bull market run, have complained that the Fed actions have artificially propped up just about every business sector. Most specifically, the financial sector.

I will agree that whenever the government is involved in these matters, then the end results are "manufactured" to a large degree. The policies are designed to create a desired result, and if that means that the stock market has created wealth since the policies were put in place, then so be it. Investors can complain until the cows come home, but if they have been prudently invested since the market collapsed, those very same complaining investors have made a bunch of money.

Let's look at some charts:

^SPX Chart

The S&P 500 has more than doubled since the "crash".

^DJI Chart

The Dow Industrials has more than doubled.

^NDX Chart

The NASDAQ indices have more than doubled.

I love charts! These state the case better than I can, that's for sure. If you were invested in the markets, you have made money, period.

OK, So What About NLY And AGNC?

Both of these companies are in the money business. Neither of these financial companies manufacture a cell phone, or sell a line of clothing, or drill for oil. Both of these companies borrow low and lend higher (or buy low and sell higher) the financial instruments within the mortgage market.

The difficulties that both companies faced was a direct result of Fed policies in the last few years. Between Operation Twist (buying longer term Treasuries) and the direct purchasing of mortgage backed securities, a tighter yield spread ensued. This action made it much more difficult for NLY and AGNC to profit.

As a result, both companies had to cut dividends, and there were some "edgy" quarters that impacted the share price of each as well. AGNC outperformed NLY, using a bit more aggressive approach by leveraging further out on the yield curve. NLY was a bit too conservative, and I believe miscalculated the stable interest rate environment that the Fed policies "artificially" created. That being said, both companies have navigated the "muddy waters" well enough to continue paying shareholders some serious dividends.

If we take a look at the high points for each company as they relate to interest rates, and yield spreads, it might shed a bright enough light on what could happen when the Fed starts cutting back.

2-Year Treasury Note Yield Chart

This chart is from 2009-2010. The key takeaways of this chart are as follows:

  • The 30 year mortgage rate was between 5-6%.
  • The 10 year Treasury rate was between 3-4%.
  • The 2 year Treasury rate was roughly 1%
  • The spread between the 2 and 10 year rates was between 2-3%.
  • The dividends paid by NLY was up to almost 70% higher than today.
  • The dividends paid by AGNC was also higher than today, but the share price was much lower back then as well.

Today, the spread between the 2 and 10 year rates sits at about 1.63%, while the short term rate is at .24%. IF the fed decides to stop buying longer term Treasuries and MBSs, the yields will rise in those treasuries.

As long as the Fed keeps ZIRP in place, then the spread can jump back up to the 2.50-2.75% range. That will give both companies an additional 100-125 basis point spread to work with. I believe we were given a hint that this scenario could actually happen, in this report, when San Francisco Federal Reserve Bank President, John Williams stated:

"I expect we will meet the test for substantial improvement in the outlook for the labor market by this summer. If that happens, we could start tapering our purchases then." ..... "If all goes as hoped, we could end the purchase program sometime late this year."..... Williams is hardly advocating an increase in short-term rates that have been near zero for more than four years; he took care to note that even if the Fed stops buying assets its $3 trillion portfolio of securities will continue to push long-term rates downwards.

That is the key folks. In my effort to keep all of this stuff simple, if the Fed keeps ZIRP and dumps the other policies, I will be thinking of increasing my current allocation in this sector to between 5-8% instead of 2-4%. If the economy has improved to the point where the "artificial" numbers can finally stand on their own, then the rest of the market should be able to continue to prosper as well.

Keep your eyes and ears open.

Disclosure: I am long NLY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.