The stock market has seen increased volatility over the past few trading sessions as investors contemplate new risks. While military engagement is extremely unlikely, Russia's invasion of Crimea has added geopolitical risk to the market and could lead to sanctions. Warring sanctions could threaten the nascent recovery in Europe, as Russia is a major supplier of natural gas and oil. While the weather has certainly impacted economic activity, there is some evidence that the economy is slowing as well. ISM data and many other surveys have been consistently disappointing while the most recent jobs report was slower than 2013's pace (economic data can be found here). Further, recent trade data from China showed exports fell 18% year over year (details available here). While there were some unique factors in the report, a drop this steep is suggestive of declining global demand.
With increased risks of slowing growth, investors cannot just buy the highest beta stocks and enjoy the upside as recent declines in stocks like Plug Power (NASDAQ:PLUG) and FuelCell (NASDAQ:FCEL) have reminded investors of the downside risk in high beta stocks. Investors should look for stocks that can perform well in a sideways or a down market while also having some upside potential. Annaly Capital (NYSE:NLY) is a perfect example of one such company. Annaly functions as a "bond equivalent" because it is an mREIT that mainly owns agency mortgage backed securities (MBS backed by Fannie and Freddie). As a consequence, Annaly is not taking credit risk (unless you consider the US government to be a credit risk). Instead, the risk lies in being poorly positioned via duration, coupons and prepayments. Subpar positioning for rising rates in 2013 did hurt Annaly's operating performance.
Even though Annaly does not take credit risk, it currently yields a fantastic 10.8% thanks to leverage. Leverage stood at 5x at the end of 2013, and Annaly systematically cut leverage during 2013 (financial and operating details available here). At the beginning of 2013, leverage was 6.5x, and leverage was 5.4x at the start of the 4th quarter. Annaly has cut leverage by selling assets. Its MBS portfolio stands at $73.4 billion, down from $127 billion a year ago. Given the rise in rates in 2013, it would have been beneficial if Annaly had cut leverage more quickly, but it is better late than never. With a leaner portfolio and interest rate swaps to hedge some risk, Annaly is much better positioned to handle rising rates in 2014 than 2013.
With increasing uncertainty about economic growth, rates should remain subdued, and I do not expect the 10-year to pass 3% in the next three months. Annaly profits the most when there is a very gradual increase in interest rates and steepening of the yield curve. Annaly invests in bonds that are mainly backed by 30-year mortgages but borrows mainly through the overnight repo rate, which is tied closely to the Fed funds rate (currently 0-0.25%). Janet Yellen, Chairman of the Federal Reserve, should continue Ben Bernanke's policy of tapering bond purchases but will likely maintain the low Fed funds rate for the next 12-18 months, which will help to gradually steepen the yield curve.
Over the next few weeks, Annaly can take advantage of increased uncertainty to further reposition its portfolio to hedge for rising rates while maintaining significant dry powder. As rates resume their increase with the Fed exiting the market, Annaly can take advantage of higher rates and redeploy capital in higher yielding assets. While its borrowing interest rate will remain low, its assets will have a higher yield, which will make purchases accretive to cash flow. If interest rates rise 1% over the next nine months and Annaly increased leverage from 5.0 to 6.0, it would be able to support a dividend of roughly $0.40 compared to the current $0.30.
At the same time, Annaly provides a significant margin of safety as it trades at a discount to its book value. Book value at the end of last quarter stood at $12.13, about 9% above current levels. In other words, if you wanted to build a portfolio of MBS, it would cost you 9% more than just buying Annaly. This discount protects investors from a sudden rise in rates, which would cut the value of Annaly's holdings. In this current period of uncertainty, Annaly provides a fantastic 10% yield, and it will be able to increase the dividend over the next 18 months as interest rates gradually increase. In other words, Annaly is a bond equivalent stock that can actually perform well if interest rates rise in a gradual (not sudden) fashion. Its discount to book value also provides a substantial margin of safety.
Now, longer-term investors need to follow any efforts to reform Fannie and Freddie. Several senators just unveiled a plan yesterday (details available here). Without a federal guarantee, Annaly and other mREITs would have to take on some credit risk, which would open the door to some losses, though some federal backstop would still likely be in place. Given the gridlock in Washington, a massive reform of the mortgage market is unlikely in the immediate term. Still, major changes could upend Annaly's model and add credit risk to its portfolio, which could force it to cut leverage in the longer term. Major reform remains unlikely, so I would continue to buy Annaly, though I would closely follow these efforts.
Overall, Annaly is a fantastic investment in a market that is seeing increased volatility. Annaly offers solid current income with a 10.8% yield, trades at a discount to book value, and can increase its payout as interest rates rise. I would continue to buy NLY here.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.