This year the market has been quite the roller coaster. But I don't need to tell you that. We need only look at the previous two weeks to understand that volatility is back in the market. While we are all in search of a superior return on our investment, it must be mentioned that those securities paying dividends tend to exhibit less risk and can provide a cushion for a portfolio's return, even in bear markets. That being said, it would be wise to take a look at Annaly Capital Management (NLY).
NLY is a Real Estate Investment Trust (REIT) that invests primarily through Mortgage Backed Securities (MBS) which are agency guaranteed. This means that payments of interest and principle are guaranteed through government sponsored agencies such as Fannie Mae, Freddie Mac and Ginnie Mae. Furthermore, because the company does not fall under the Securities Act of 1940, the company has been able to leverage its equity up to almost 6 times value through the use of repurchase agreements.
Since these repurchase agreements are a crucial part to NLY's success, it is important to understand how the process works. A repurchase agreement acts as a temporary, typically overnight, loan that is backed by Treasury certificates (bonds and bills) as collateral. In return for borrowing the money, the fund will pay a small interest charge that is called the REPO (for repurchase) rate. These agreements carry minimal credit risk because they are collateral backed and of such short term duration. However, 3 or 4 months ago, when the U.S. was lingering around the fine line of defaulting on its debt, the perceived value of Treasuries (the most common asset for backing repos) had decreased, thus requiring REITs to post higher amounts of collateral.
Therefore, during June and July, asset management companies needed to have greater "cash equivalents" necessary in the event of a U.S. default. As a result, NLY was forced to decrease its leverage ratio during Q2. Since then, the Company has been able to expand the leverage ratio and in addition, because REPO rates have decreased, lower their borrowing costs. In fact, the average REPO rate during Q2 was approximately .090778% while over the past 90 days that average has decreased by slightly more than 7-tenths of a basis point. This small differential may seem inconsequential, however when operating with $73.5 Billion in assets, such a small differential can mean millions saved on the bottom line.
All looks well and good for NLY, however to be fair, the disadvantages should be pointed out. Due to decreasing interest rates, property owners are looking to refinance their mortgages. This brings prepayment risk to light with regard to NLY's MBS investments. If the securitized mortgages are prepaid, those "anticipated" interest payments are lost and thus so is the anticipated ROI. This prepayment will also initiate a second, reinvestment risk. Since current fixed rates are so low, the management team will be unable to replace the higher yielding mortgage backed securities which were paid off.
At this point, it is my opinion that if borrowers were to have refinanced, they would have done so by now, when mortgage rates made their initial decline. As a former retail branch banker for an industry leading bank, I can tell you with conviction that commercial banks such as Chase (JPM) and Bank of America (BAC) were having employees actively sift through their databases to find customers who could benefit from refinancing their current mortgages.
Those customers who haven't already refinanced are either unable to due to having a current mortgage that is underwater, do not have proper documentation (since the crisis, mortgage loans have become increasingly more complex), or do not wish to be bothered with the process involved in a refinance.
To entice investors even further, currently NLY trades approximately 6% below book value as well as below the 5-year average Price-To-Book value ratio. NLY is undervalued by other metrics as well including its Price to Earnings, Price to Sales and Price to Cash Flow ratios, all relative to the management company's 5 year average.
NLY yields 15.8%, all of which is distributed as income, unlike other high yielding funds which commonly have a portion of their distribution classified as a return of capital.
What it all boils down to is that we're looking at (in my opinion) an undervalued asset with an exceptional yield. Which makes it perfect for an IRA, where you can reinvest dividends and not worry about paying taxes on distributions.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in NLY over the next 72 hours.
