The Better 7.5% Yield

| About: Annaly Capital (NLY)

Summary

Annaly Capital Management has four shares of preferred stock, but the market failed in pricing them.

The E series is not getting enough love from the market.

The price discrepancy between the D series and the E series causes the E series to be a materially better investment.

Annaly Capital Management (NYSE:NLY) is the largest mortgage REIT. There are some advantages to being the biggest. Among those advantages are the ability to achieve economies of scale and a more efficient market for your shares. However, the common stock being more efficient than the common stock for most other mortgage REITs says very little about the preferred shares. Despite the liquidation value on the preferred shares having a total value of over $1.2 billion (larger than the market capitalization of several mortgage REITs), there are still some material pricing failures.

For the investor seeking a stable dividend yield and less volatility in the share price, the preferred shares can be a great opportunity. The dividend on the preferred shares is usually materially lower than the dividend on common shares, but the price stability and lack of cuts in the preferred dividend offset the lower yield.

After absorbing Hatteras Financial Corp. (NYSE:HTS), Annaly Capital Management took over their preferred shares as well. Rather than paying the shares off at par value, Annaly Capital Management wanted to take advantage of the financing. That makes some sense, since the rate on the shares matches the rate on the C series of NLY preferred shares.

Four Series

There are now four series of preferred shares; they are NLY-A, NLY-C, NLY-D, and NLY-E. The newest one is NLY-E. I have some nice tables for analyzing preferred shares. See the table below for the comparison:

Click to enlarge

The prices listed in column 5 indicate the latest price as of the weekend. Prior to writing this article, I checked the prices on Tuesday morning. The only movement larger than $.10 was NLY-A, which was up $.18.

The high and low values provided for each mortgage REIT are based on their highs and lows from the end of June 2015 to the end of June 2016, so new price records set in July are removed. Having a static valuation period can be helpful since it shows when shares are moving beyond their previous range.

Shares of NLY-A

Shares of NLY-A are just moving too high with the movements so far this week. The increase of $.18 takes them too high given the call risk. Shareholders buying into NLY-A are buying a security that is exposed to call risk with the call value being materially lower than the current price.

The more interesting divergence though is between shares of NLY-D and NLY-E. The shares of NLY-E carry a slightly higher dividend rate. NLY-D has a quarterly dividend payment of $.4688. NLY-E has a quarterly dividend payment of $.4766. The difference is fairly slight, but it should make investors wonder why NLY-E sells at a lower price than NLY-D.

Not Call Risk

Annaly Capital Management stated they intended to keep the shares, rather than paying them off during the merger (an exception to the call protection). They also completed the acquisition and moved the shares, previously HTS-A, over to the ticker NLY-E.

NLY-E will be eligible for a regular call at $25 on or after 8/27/2017. Shares of NLY-D have their protection out to 9/13/2017. Since called shares receive the call value plus the accrued dividend, the difference in potential call value is only the difference in dividend accrual. That difference would be paying shareholders for the extra 2.5 weeks or so of holding the shares.

After 9/13/2017, there is no difference in call protection. So after 9/13/2017, would you rather have the security that pays a slightly larger dividend or a slightly smaller dividend?

I imagine shareholders would prefer the larger dividend. Therefore, I would expect NLY-E to trade at a price equal or higher than NLY-D.

Even if shares of both securities are called immediately upon their call protection ending, shares of NLY-E win. I estimate that shareholders of NLY-D would have received their initial purchase price plus $1.61 over the holding period. Shareholders of NLY-E on the other hand would get back their initial price plus $1.81.

This all begs the question, why are shares of NLY-E trading about $.42 lower than NLY-D?

The Simplest Option is Best

Over the time I spent covering preferred shares, I found quite a few times when the preferred shares of a company did not reflect the relative value between the classes of preferred shares. One reason for this divergence is a lack of coverage on preferred shares. A second potential reason is because many screening tools still aren't providing the right data on NLY-E.

I used my Charles Schwab account to look up the preferred shares for Annaly Capital Management. Great data is available for NLY-A, NLY-C, and NLY-D. Shares of NLY-E do not have the same technical data (IE price charts with volume overlays) available yet. Consequently, I think many investors may assume something is wrong with NLY-E. It is worth noting that the trade screens can pull up the necessary trading information correctly. The only thing missing is the charting features and the coverage necessary to tell investors that NLY-E looks just fine.

Quick Comparison to NLY-C

The difference between NLY-C and NLY-E (same dividend rate) is simply that NLY-E carries a longer call protection than NLY-C. Of course, NLY-E also has a lower price so it produces a higher stripped yield as well.

Conclusion

Shareholders looking for more stability in their investments should consider using preferred shares. When it comes to Annaly Capital Management, the E series is offering the best deal. The most notable difference is between NLY-D and NLY-E where investors can get 20 extra basis points of yield for taking NLY-E. The call protection ends slightly sooner, but shares of NLY-E would still outperform because they trade at a smaller premium to call value.

I expect the E series to outperform by about $.32 to $.35. After that, the risk/reward ratio between the C series, D series, and E series will be relatively even.

Subscribers received my assessment of the preferred shares over the weekend so they could be ready on Monday morning. The assessment covers the preferred shares of each mortgage REIT.

Want to Know More About Mortgage REITs and Preferred Shares?

Since the Mortgage REIT Forum is a new exclusive research platform, the first 100 subscribers will be able to lock in their subscription rates at only $240/year. My investment ideas emphasize finding undervalued mortgage REITs, triple net lease REITs, and preferred shares. With the market at relatively high levels, there is also significant work on finding which securities are overvalued to protect investors from losing a chunk of their portfolio.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in NLY-E over 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.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.