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Annaly Capital Management (NYSE:NLY) has plummeted in 2013. Investors who bought in for the dividend yields of 12%-13% are now facing losses of 30% or more and will require a few years of dividends to recover the unrealized capital losses. The selloff has been in response to two major concerns; the belief that the Federal Reserve may slow or cease its mortgage asset purchases sometime this year and the fear that rising interest rates will crush portfolio holdings of the mortgage real estate investment trusts (mREITS). The last wave of extreme selling occurred on Friday July 15th and was a direct result of another better than expected jobs number showing that the economy added 195,000 jobs in June. About midday on July 5th, when NLY was trading down 6.0% at $11.40, I came out with a call to buy the panic selling in NLY's main competitor American Capital Agency (NASDAQ:AGNC), as I viewed the selling as overdone in the entire sector. Since then, at the time of this writing both stocks are up over 7%. Still, despite the evidence I have laid out in multiple articles and despite the fact that closer examination of the jobs number revealed a still gloomy view of the economy, countless article comments and personal correspondences I have received have one common question that is prevalent; "is it time to abandon ship on annaly"? I generally respond by saying something along the lines of "despite NLY shedding about a third of its share price since April, if you truly believe the sector is still doomed, then you could sell into this nice rally". However, there are a few reasons I have yet to discuss in detail as to why NLY may not go the way of the Titanic, and although shareholders are a bit under water right now, the holes in the ship may be getting plugged.

Fed Just Isn't Ready to Let the Economy Go

Ok to put some context into the maritime analogies in the introduction, let us look to the data. Upon the release of the latest FOMC meeting minutes, combined with Ben Bernanke's comments in Boston following their release, NLY saw a nice bump. There was some good news there, which ran contrary to the reasons people were abandoning ship. The meeting minutes clearly indicated that every FOMC member except one had called for extending the Fed's current economic stimulus program, as opposed to the big bad scary iceberg (to continue the maritime theme) that is 'tapering.' The fact of the matter is that whether or not we agree with Fed's decisions and their impact on the future of the American economy, the committee members led by Ben Bernanke are simply not going to pull the stimulus plug and risk jeopardizing everything their great experiment has achieved. When they look at the data and the information available in regards to the economy, they know it is not all visions of rainbows and butterflies and 72 degree sunny weather. They see that the economic gloom persists. Thus, they did not advocate for tapering of asset purchases because there is not stable economic news to justify it, nor have the economic goals that were laid out when the program was announced been met.

One key issue that isn't being given a fair look by the economic pundits, in my view, is that the issue of short-term interest rates was discussed heavily at the meeting. Further, the FOMC was adamant that the low-rate situation, or the zero rate interest policy (ZIRP), will not change until the unemployment rate drops to 6.5%. This is not likely until late 2014 or 2015. Further, Ben Bernanke said in Boston that the current unemployment rate of 7.6% might be overstating the "health of the labor market," and as such "highly accommodative monetary policy for the foreseeable future is what's needed." Translation: keep the printing presses on and the mortgage purchases coming. We cannot stop now, because we may risk wasting a trillion dollars. It has been working, slowly.

Let Me Be Clear, There Are Benefits of Rising Interest Rates.

The short-term pain from rising interest rates has been damaging to NLY because of the impact to the value of mortgage backed securities. It could be another ugly quarter, as there may be a large mark-to-market asset write down as of June 30th because of the mortgage market price collapse. Equity could diminish and could put the leveraged players at risk of having to de-lever pushing the market prices even lower. Yet in the long-term, NLY stands to gain from rising rates. The Fed has kept short-term buying rates near zero levels, and this is about the rate at which NLY can borrow money. The Fed, as evidenced in the minutes cited above, has just told us that low rates are here to stay at least until unemployment hits 6.5%. Prior to this release, Atlanta Federal Reserve President Dennis Lockhart recently spoke in which he said that nothing has changed in the Fed's overall monetary policy. He also said that the Fed "wouldn't consider raising interest rates until 2015". Thus, for the time being, it will not cost more for NLY to borrow relative to the last few years. In fact this was supported in the recent comments following the FOMC meeting "the committee decided to keep the target range for the federal funds rate at zero to one-quarter percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above six and a half percent."

The Fed will also keep rates lower so long as "inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's two percent longer-run goal." Keeping the short-term borrowing rates low is key to the mREITs being successful going forward. As the longer-term rates rise while the borrowing rate remains stagnant, the interest rate spread (that is the difference between what NLY pays to borrow and lend) will widen, subsequently feeding the top and bottom lines. This last quarter or two have been periods of transition, where existing holdings in the portfolios have declined, been possibly sold, and the proceeds used to re-weight the portfolio.

One criticism I have received from individuals who believe it is time to abandon the NLY ship is that my analyses lack what happens when the short-term rates do rise. Skeptics point to the ten year treasury having spiked to 2.71% as an example. My response is generally that when you buy a stock, you are buying the management team. NLY's management team is top notch and is well compensated for doing so. Their team is among the best in the business. I have confidence that my recent decision to pyramid down into this name along with other mREITS is wise, despite the short-term headwinds the company has faced. They key for the quarter that just ended will be how well their hedges performed. Management has known rising rates would be coming eventually and I will be watching with great angst to see how their hedges have performed when the company reports its Q2. I will also add that when short-term rates rise, it will be detrimental only if long-term rates remain stagnant, or worse start to decrease while the short-term rates rise. Further, there is one thing that NLY has that I think will help diversify it and maintain its staying power for years to come: commercial real estate exposure

By Diversifying into Commercial Real Estate, NLY Has Secured Another Revenue Stream

As you may be aware, I have encouraged mREIT investors to consider diversifying into hybrid mREITs (such as MTGE), which are companies that have exposure to both residential MBS and commercial-backed mortgage securities. NLY has always been heavily invested in residential MBS. However, given the market climate, management has recognized that the commercial real estate market has yet to pick up steam compared to the residential market. The one thing NLY has (that AGNC does not), which makes me believe in owning this stock for the long-term regardless of the headline risk and short-term volatility, is that the company has recently completed the purchase of CreXus (NYSE:CXS).

This purchase is critical because it will offer NLY massive diversification advantages. CreXus acquires, manages and finances, directly or through its subsidiaries, commercial mortgage loans and other commercial real estate debt, commercial real property, commercial mortgage-backed securities and other commercial and residential real estate-related assets. Also, NLY has renamed the company to Annaly Commercial Real Estate Group. This purchase will allow NLY to diversify its investment portfolio and when commercial real estate mortgage picks up, it will help future earnings growth. Chief Executive and Chair of the Board Wellington Denahan said of the acquisition during the last conference call:

"The CreXus's acquisition is accretive to the Annaly dividend and represents a meaningful step in the evolution of Annaly's capital allocation strategy, one that will enable us to take advantage of a broader spectrum of investments. Since the announcement of this acquisition in November, we have continued to build out our commercial expertise and we remain confident that CreXus' capabilities and growth may be significantly enhanced when coupled with Annaly's broader capital base."

It is not a secret that the commercial real estate market has lagged the residential real estate market. Being focused on residential MBS concentrates risk, thus an added layer of diversification is wise. With evidence that the US economy is on the rebound, it is likely the commercial mortgage market will be a significant source of revenue moving forward. Thus, NLY has wisely taken steps so that it will not be down and out for long, and can emerge from the woes of 2013 much stronger.

Takeaway

As a long-term investor, I think it is prudent to buy stocks that are on sale during times of panic provided the management team is sound and the business model still works. NLY has been under pressure as has the entire mREIT sector. The evidence presented above indicates that the mREITs are still a place to invest, specifically because the Fed is keeping borrowing rates low and asset purchasing is not ceasing anytime soon, as nearly all of the FOMC is feeling dovish. In fact, NLY is on sale after losing a third of its share price. There is some potential downside following Q2 earnings, but this company has staying power. It has been around for a long time and has taken the necessary steps for survival. There is no doubt the company is in transition. The earnings report and conference call will give clear direction as to what management is planning and how their hedges are performing. Because much of the fear in these names has been over the Fed ceasing asset purchasing as early as September, and the fact that rising interest rates are not necessarily bad for NLY long-term, I argue that it is not time to give up on the stock. This is especially true given the diversification into commercial real estate, which is just entering a new cycle. As painful as it can be, you have to hold during these times or buy more if you want to make a profit. The weaker companies may underperform significantly and some could go belly up, but NLY has staying power. In a sector like this it is also prudent to remember that your buying strategy and timing are everything. The Fed has telegraphed low rates and continued asset purchasing. Combined with the dramatic decline in share price, the prospects for the company moving forward and the skilled management team, NLY under $12.00 is a buy.

Source: Annaly Capital: Is It Time To Abandon Ship?