As we stated in a recent article, we are still bullish on NLY because we think agency REITs continue to be a suitable investment for investors seeking good risk-adjusted yield. Agency mortgages are guaranteed by government sponsored entities (implying limited credit risk). Conversely, non-agency securities do not carry a similar implied guarantee, making them inherently more risky due to the higher relative credit risk.
Agency Mortgage REITs provide yield hungry investors access to strong dividend yields. These securities typically perform well in low-interest-rate environments with steep yield curves. We think they provide investors a hedge against heavy cash and short-term bond portfolios in the event interest rates stay low for an exceptionally long period of time.
Also, NLY management has slowly been reducing its leverage, which has been the main driver of the recent dividend reduction (not higher CPRs like the other article suggests). While lower leverage leads to lower profits (and dividends), it also reduces risk. We view this as a positive risk management technique, which is why we are still bullish on NLY.
Fighting Fire With Fire
There are many prominent fund managers that are still bullish on NLY, one of which is PIMCO's Bill Gross.
The phrase “this time is different” can be a costly one for investors. With that caveat we think that investors, economists and policymakers are focused on quick solutions that have worked during cyclical downturns. Central bankers have been trained to believe that as the economy weakens that lowering interest rates stimulates the economy. In a recent article from Bill Gross entitled The ugly side of ultra-cheap money, Gross discusses how ultra low, zero-bound central bank policy rates might delever as opposed to relever the financial system. In his article Gross discusses how ultra low rates have broken the business model of the money market business as current yields do not cover operating expenses. The decline in money market assets reduces leverage in the system as funds move to banks, which invest in Fed reserves as opposed to private market credit.
PIMCO has discussed the idea of financial repression in the developed world where rates are kept low, below inflation, while funds are channeled to the government. Under a strategy of financial repression, governments often require banks, pension funds and other financial institutions to hold government debt, ostensibly for reasons related to the safety and soundness of the organizations concerned. In today’s environment reserve requirements for U.S. government securities create an incentive to purchase and hold these securities, effectively funding government spending.
Investors should look for securities that will benefit from ultra low interest rate policy. Gross has touted NLY. Annaly is an agency mREIT, which effectively borrow short rates and acquire mortgage backed securities which generate higher yields. Vehicles such as NLY make money by “playing the spread” or the net interest margin.