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On Monday August 19, the yield on the 10-year treasury surpassed 2.90%, capping off what has been a virtually unprecedented rally in interest rates. Back in May, the 10 year yielded a paltry 1.63%, but since Chairman Ben Bernanke first spoke of tapering Fed purchases rates have jumped by 78%. This rally has dwarfed even the record setting move in 1994. Obviously, during this time interest rate sensitive sectors like mortgage REITs, utilities, MLPs, and blue chip dividend stocks (i.e. VZ and T) have been crushed. Consider that in the past three months Kinder Morgan Energy Partners (NYSE:KMP) is down 7.9%, FirstEnergy (NYSE:FE) 16.9%, Verizon (NYSE:VZ) 11%, and Annaly Capital (NYSE:NLY) 29%. So is now the time to get in and buy interest rate dependent stocks, or should we avoid them like the plague?

I contend that we have seen the vast majority of the move up in interest rates, and if anything, rates should decline from here. Given this thesis, several beaten-down stocks are appealing. Over the past 100 years, the 10-year treasury rate has been roughly equal to nominal GDP growth (real growth plus inflation). The US economy is growing at 1.5%-2% while the PCE is running around 1-1.25%. This would suggest a "fair" 10-year yield of approximately 3%, worst case 3.25%. Looking from this angle, it would seem that the move in treasuries to the upside could be over. However, we do need to recognize that these are not normal times as the Federal Reserve holds more than $1 trillion in treasuries and has been buying $40 billion more monthly. Given this extra source of demand, the 10 year should yield less than its historical norm. In my opinion, a more appropriate yield is probably closer to 2.5%.

Some have argued that yes the Fed has been very stimulative, but it's about to pull back the stimulus. They argue this tightening ("the taper") will send rates spiraling higher. This view is perhaps the greatest misconception surrounding the taper. Tapering is not a tightening of monetary policy but rather a less-easy monetary policy. The "tightest" policy under consideration would be a reduction from $85 to $65 billion in monthly purchases announced at the September 17-18 meeting. In other words, the Fed will still be exerting downward pressure on rates for the foreseeable future. An easy Fed means lower interest rates.

Admittedly, markets almost overdo every move. Given that markets are relatively illiquid in front of Labor Day, it is very possible that momentum carries the 10-year yield a bit further for another week. Still structurally speaking, the move in yields should be over in the next week or two, and I expect we will retrace upwards of 50bp during the rest of the year. At this juncture, the best strategy is to bet that interest rates are going to tick back down.

There are several different ways to play this reversal in the bond market. Buying a straight up dividend stock is one simple way to do so. As the 10 year yields less, the value of dividends increase. Participants then buy the stock, pushing up the price until that dividend yield drops appropriately in relationship to the 10 year. For instance, consider playing a KMP, which has a strong asset base, and is a bond-like stock (trades in-line with treasuries). Having raised its dividend in the past month, it could jump back over $85 when rates pull back. You also collect 6.3% while you wait.

For those who are concerned about increasing rates longer term, but think the near term move is mostly behind us, there may be no better choice than Prospect Capital (NASDAQ:PSEC). This business development company lends to midsize companies (less than $250 million in revenue) and passes on 90% of profits to shareholders. Because it doesn't retain much earnings, the vast majority of shareholder returns come in the form of dividends not share appreciation, similar to a bond where the coupon provides the return. Interestingly, PSEC borrows at a fixed rate while lending at a floating rate (typically benchmarked to LIBOR with a floor of at least 7%). The stock currently offers a 12% yield, but a dropping 10 year increases the present value of payments while lowering the market's required rate of return. This combination could give PSEC a nice boost. In the medium term, this company benefits from a rising rate environment. PSEC is an interesting play if you see rates dropping in the next 3-6 months and then soaring beyond 2014 when the Fed actually tightens.

If you're interested in a pure short-term trade, my preferred choice is Annaly Capital. As mentioned above, the stock has been absolutely slaughtered. It's down nearly 30% in 3 months. In fact, NLY now trades at a discount to book value-it could rally 20% from here before surpassing its book. With its stellar management team, this company should really trade at a premium to book. As an investor in mortgage-backed securities, its portfolio has obviously been taking a hit in a rising rate environment, but NLY was not caught flat-footed.

In the second quarter as rates rose, the firm sold $14 billion in assets, cutting its leverage ratio from 6.6 to 6.2, helping to blunt the impact of decline in prices. During 2013, it has sold $31 billion in mortgages, cutting assets from $133 to $102 billion. Yes a smaller asset base decreases potential dividends, but by cutting leverage NLY has fresh powder. It now has the capacity to buy mortgages cheaply, which will profit shareholders nicely. We also need to recognize that now is a good time to own mortgages. With the low in interest rates likely set (we likely won't return to 1.6% in treasuries), the refinancing wave is over. As such, over the next 5 years prepayment rates should run at or below historical levels, which guarantees the coupon these bonds offer. In this environment, it is hard to see firms like NLY taking losses on bonds they hold to maturity.

In the worst-case scenario where NLY doesn't add to its holdings, and where its interest rate spread falls to 0.9%, it still can support a dividend of $1.00-$1.10 for a juicy 10% yield. Again, that is the worst case! More likely, it can add to its asset base while prices are low and as rates retrace lower the value of its entire portfolio increases in value. In this environment, the stock will return to book value, or $13 by Thanksgiving. With its 14% yield, there is a great margin of safety. NLY is a leveraged bet that the rate rise is finished and overdone.

Conclusion:

With treasuries back at a historically normal level, rates are due for a pullback as the Fed will continue to exert downward pressure. In this environment, it is time to make a contrarian bet by focusing on stocks that derive the majority of their performance from dividends like MLPs. Mortgage REITs provide a leveraged bet on interest rates with Annaly Capital setting up nicely on the long side.

Source: Buy Annaly To Profit From A Rate Pullback

Additional disclosure: I also am considering NLY should it fall below $10