The Federal Reserve surprised yesterday opting to delay the start of tapering. For now, it will maintain its $85 billion per month asset purchase program. Although some employment indicators point to an improvement in the labor market, the Fed considers that the unemployment rate remains high and if the tightening in financial conditions of the last few months persists, it could slow down the economic recovery. Since May, when Ben Bernanke started discussing the start of tapering, interest rates have gone up considerably. The yield on the 10-year Treasury bond has increased from 1.6% on May 1 to about 2.90% yesterday, but after the announcement of no tapering for now it declined rapidly to 2.70% as I write. Correspondingly, mortgage rates also spiked to over 4%, leading to losses on mortgage securities.
One group of stocks that was especially hurt by increasing interest rates was mortgage REITs, which are very susceptible to the risk of rising short-term rates. Over the past few years, mortgage real estate investment trusts [REIT] have benefited from the Fed's easy money policy, which make financing cheap allowing mortgage REITs to use leverage to provide an attractive yield. The prospect that Fed's near-zero interest rate monetary policy could end over the next couple of years, make mortgage REITs to collapse. This raises funding costs and rising long-term rates weigh on the book value of existing mortgage REITs, leading to a massive sell-off across the sector. However, the surprising move taken by the Fed may be a good opportunity to buy mortgage REITs, as the economy is probably too much weak for the Fed change its monetary policy during the next few months or years as I discussed in my previous article published in June Why the Fed will not taper.
Therefore, a good way to play the expected recovery in the mortgage REITs may be through Annaly Capital Management (NLY), the largest mortgage REIT listed on the New York Stock Exchange. The trust was founded in 1997 and has currently a market capitalization of about $11.8 billion.
Annaly Capital is a mortgage REIT that offers a very simple and effective business model, which consists in making money by borrowing short-term at close to zero cost and then invests that capital in long-term, government-sponsored, mortgage-backed securities from Freddie Mac (FMCC.OB), Fannie Mae (FNMA.OB), and Ginnie Mae. Therefore, for Annaly to be profitable funding costs just have to remain low and the spread between short and long-term interest rates must be positive. If these two factors remain unchanged Annaly's business model is very stable and safe, but since May that has not happened leading to a huge stock price decline. Annaly was trading as high as $16 a share in early May but is now in the $12 range.
However, this may present an opportunity as higher interest rates are now priced-in on Annaly's stock price, and the steeper yield curve will mean higher profits for the next few quarters because the bigger the difference between Annaly's borrowing costs and its return on the mortgage securities it buys the bigger the profits. Although interest rates have spiked recently, it shouldn't move significantly higher over the next few months as the Fed does not appear ready to withdraw its quantitative easing policy. For Annaly's shareholders, this means its dividends appear secure for the next few months. At Annaly's current share price it offers an attractive dividend yield of 12.7%.
Over the last twelve months, Annaly has paid $1.80 in dividends trough four quarterly payments. Although the dividend was cut from $0.50 to $0.40 during this period, it should recover over the next few quarters as Annaly's profits improve. Moreover, its dividend history is quite impressive as Annaly has been paying large dividends to its shareholders since it was founded. Even during the global financial crisis of 2008-09, Annaly paid hefty dividends that were rapidly raised in mid-2009. On the other hand, its dividend is quite volatile so Annaly may be not suitable for more risk-averse income investors.
Regarding the dividend sustainability, Annaly's funds from operations have exceeded dividends cash outflows over the past few years. In 2012, Annaly spent $2.6 billion in dividends which were fully covered by its funds from operations of $7.6 billion. However, during the past two quarters Annaly's cash flow has been negative, something that should change over the next quarters if interest rates don't rise much more.
Moreover, Annaly is currently trading below is tangible book value of $12.89 per share as of 30 June, 2013. As Annaly's management has decided to refrain from hedging all rate risk, its book value increases with the recent fall in interest rates which makes Annaly undervalued at current levels.
The Federal Reserve should not change its near-zero interest rate policy for the next couple of years, and tapering will probably only start in 2014. The recent rise on long-term interest rates is already priced-in on Annaly's stock price, so now appears a good time to buy Annaly given the reversal of expectations regarding higher interest rates in the near future. With a dividend yield of !2.7% shareholders are well rewarded to see over the next few months if the Fed can withdraw its quantitative easing policy as it was expecting, something I seriously doubt.