Since the financial crisis, interest rates have been extremely low with the Federal Reserve maintaining a 0-0.25% overnight fed funds rate and buying long term bonds to keep those rates down as well. As a consequence, it has been difficult for income oriented investors to find quality fixed income products that can generate a high enough yield. This chase for yield has pushed investors into riskier products like junk bonds. This hunt for yield has brought investors to a new place: Greece.
Greece, ground zero of the eurozone debt crisis, is returning the debt markets and issuing 2 billion euros worth of 5-year notes. Demand is more than five times this offering, and as a consequence, the yield will be a surprisingly low 5-5.25% (details available here). This is despite the fact that Greece remains highly indebted, essentially defaulted just a few years ago, and has a relatively weak economy, though it is showing signs of a rebound.
Still, this yield is surprisingly low for an indisputably weak sovereign. Investors also face currency risk. The European Central Bank may be forced to engage in some sort of quantitative easing to spur growth and inflation. This strategy could push the euro lower, wiping out some of this yield. Further, the Greece recovery is not a foregone conclusion. Debt to GDP should also hit 190% over the next few years, so any economic problems could easily force losses onto Greek bondholders. In the search for yield, investors are taking on significant risks without receiving much compensation. A 5% yield is really not that much given these challenges.
I appreciate that many investors, particularly retirees, rely on the income from their portfolio to sustain themselves. For these investors who focus on fixed income products and fear the extra risk of equities, it has been a difficult few years. However, there are better options than buying Greek debt, including stocks that function as bond market equivalents. In particular, I would suggest investing in Annaly Capital Management (NYSE:NLY). Now, I should also note that this Greece offering is not an isolated example of a high-risk, low-yield bond. Junks bonds (NYSEARCA:JNK) are now yielding about 5.85%. Simply put, the search for yield has depressed the rates of higher risk products across the board.
Many investors are trained to think that bonds are safer than stocks. As a general rule of thumb, this assumption holds. Owning treasuries or high quality corporate bonds typically carry less risk than an equity portfolio because the US can always print more dollars to pay you back and debt is higher than equity in the corporate capital structure. Still, this does not mean that every bond is a safer investment than every stock. As a consequence, an income investor who has been searching for yield likely has holdings that are riskier than Annaly and some other equities.
Annaly is a mortgage REIT. Essentially, it (almost exclusively) buys agency mortgage backed securities and pays out the interest to investors. At the end of the day, these bonds are backed by the Fannie and Freddie, which means they are backed by the government, so Annaly is taking virtually no credit risk. However, Annaly is currently paying a 10.5% dividend, which is better than the yield you can get on some of the riskiest debt. This is because Annaly uses leverage to buy more bonds, which enhances its dividend capacity.
As of last quarter, leverage stood at 5x (financial and operating data available here). Annaly is able to take this leverage because its bonds lack credit risk. The only risk Annaly face is being poorly positioned via duration, coupons, and prepayments. When interest rates rise, the fair value of Annaly's portfolio falls, which functions to increase leverage. As rates rose in 2013, Annaly sold bonds to bring down leverage from 6.5x to 5x. Its total portfolio shrunk from $127 billion to $73.4 billion. It would have been better for Annaly to sell bonds earlier to avoid some losses, but it now had dry powder to purchase bonds and reload its portfolio as rates rise.
Annaly does best when the curve gradually steepens. It borrows on the overnight market to fund its leverage but invests in bonds with several years of duration. If the curve gradually steepens over the next twelve months, it can add leverage by buying higher yielding bonds, and its hedge book should offset any declines in the existing portfolio, which is continually seeing some run-off anyway. If interest rates gradually rise 1% over the next 9-12 months and Annaly slowly increased leverage back to 6x, it could support a quarterly dividend of $0.40 compared to the current $0.30.
Importantly after cutting its dividend last year, Annaly was able to maintain a $0.30 quarterly payout this past quarter as the bond market calmed down. By cutting leverage, Annaly is less exposed to rates, and we are likely going to see a steeper curve over the next year than we do today. That is supportive of the dividend. I firmly believe the $0.30 quarterly payout is safe and will likely increase in the coming months. Book value is also $12.13, which is nearly 7% above current levels. It is cheaper to buy NLY stock than build its portfolio yourself.
Income investors are primarily focused on earnings a decent yield without taking too much risk. In today's bond market, that is all but impossible. Even Greece, which still has troubled financials and a terrible history of meeting its obligations, is borrowing at only 5-5.25%. US junk bonds are really no better and provide little cushion against an increase in defaults. While NLY is an equity, it offers a higher yield and is really a safer investment. It trades below book value, providing an immediate margin of safety. Further, there is virtually no credit risk as it mainly deals in agency MBS. The firm does employ leverage, but it is currently at a relatively low level, which makes further significant book value erosion unlikely. If rates gradually rise, Annaly can also pay out a higher dividend, something traditional bonds do not do. At current yields, income investors are better buying Annaly stock and earning 10.5% than buying Greek or junk bonds and getting 5-6%. Sometimes, certain stocks are less risky (and provide more reward) than some bonds. In the current fixed income environment, NLY is one such stock.
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.