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Annaly Capital Management (NYSE:NLY) seems to be one of the most popular investments for income investors given its current dividend yield of 14%. After all, 14% is two times what you can make on most high yield issues, nevermind the skinny yields on most common equity.

One thing that somewhat surprises me, however, is that the discussion almost always comes down to yield. Yield is a function of price, which is a function of dividends and riskiness (perceived volatility in dividends, portfolio etc). I have heard all too often that the mREIT sector is less volatile than the market. This may be true as measured by beta derived from the S&P index (indices), but it does not mean the volatility is low in absolute terms.

Enough of the macro opining though and back to Annaly. Volatility in Annaly does exist, so one has to consider the range of possible outcomes given the standard deviation of price returns (yes, I realize that total return encompasses both price and yield, but an mREITs price more often reflects dividend/yield, so I felt it reasonable to begin with price volatility). Looking at ten years of monthly price returns and calculating the standard deviation of rolling twelve month returns, I came up with the following:


Returns are price returns and standard deviation has been calculated utilizing lognormal functions given the increased accuracy and tendency of returns to be lognormally distributed.

Recall that 95% of all occurrences will fall within two standard deviations (Forever ingrained in my brain by a ruthless grad school stats teacher and the CFA curriculum). As most income investors see upside as gravy and downside risk control as paramount (forgive me if I generalize), we can then imply that approximately 95% of the time we can expect the change in price to be +/- 14.4% from the mean change in price of approximately 1%. In a downside framework, that means we could see the price fall by approximately 13%.

What would cause a fall in the shares? Well, in the mREIT space it would be a negative expectation of portfolio leverage and returns and the corresponding reduction in the dividend. And yes, even Annaly's dividend goes down:


A snapshot of their leverage is:

Okay, now we have shown it is possible for the dividend to go down (not being a condescending idiot, I swear - just trying to address the reality in order to make the point of my article). I know what you are thinking right now: "and this means what aside from you can regurgitate statistics and make theoretical statements." Well, I am getting to that, please bear with me.

The purpose of this article is to determine if the preferred stock of Annaly (NLY-A) is a viable alternative to the common shares for income investors.

First, a snapshot of the preferred:


Note that I have adjusted the price to strip out the accrued dividend. I have done this because this is what you are paying for the preferred stock ($26.42) and you are buying $0.08 of accrued dividend. I have, in the snapshot, assumed the issue is called within three months to determine the yield to worst, which is a rather dreadful -10.5%.

The first thing that should jump out at you is that the issue is currently callable and trades at a premium. This, to many investors is a big flashing red light and blaring siren due to the fact that the issue can get called (or redeemed as I was once castigated in a comment) at $25 and your immediate loss is $1.42 or approximately 5% (recall that yield to call is an annualized number and the loss here is just your price loss - you get the accumulated dividend). Below I have laid out a couple of scenarios for call dates and their corresponding yield to call:


The breakeven holding period (0% yield to call) is three quarters (75% of one year). A logical question is why is three years the best case scenario when we are looking at a rising rate environment. The simple answer is because I an trying to be conservative as we are downside risk averse.

Now the question becomes: "where could Annaly get a new preferred deal done to replace the Series A?" The answer is simple: I don't know. I can, however say that on March 12, 2012, Colony Financial (NYSE:CLNY) sold 5,200,000 shares of 8.50% Series A Cumulative Perpetual Preferred Stock.

In case you are not familiar with them, Colony Financial is a commercial real estate finance company engaged in acquiring, originating, investing in, financing and managing a diversified portfolio of real estate-related debt investments, with a primary focus on commercial mortgage loans (which may be performing, sub-performing or non-performing loans), CMBS, mezzanine loans, real estate owned properties, debtor-in-possession loans, B-notes, bridge loans and other commercial real estate-related debt investments.

They obviously have more risk in their portfolio than Annaly, so if we were to trade Annaly 100bps through them, we would come up with 7.5%. To refund at this level would save Annaly 37.5bps per year or $400,000. The underwriting discounts and commissions paid on the Series A (4,250,000 shares of $25 par or $106.5 million) was $3.3 million. At 7.5%, it does not seem all that economic to redeem the issue with another preferred issue.

Another indicator of where they might be able to fund is where another mREIT trades. Anworth Mortgage Asset Corp. (NYSE:ANH), 6.25% Series B Cumul Conv Preferred Stock trades at 6.36%, but this is a convertible. Anworth Mortgage Asset Corp., 8.625% Series A Cumul Preferred Stock trades at an 8.24% yield - currently callable.

Using these limited datapoints, it does not appear than Annaly could fund cheap enough to make it financially worthwhile. If that is the case, then the current yield of 7.53% might be safe.

Bottom line: If you see hard times coming at Annaly in terms of their portfolio performance or dividend sustainability (referring to the leverage chart above and recognizing the spread compression occurring within the portfolio, if they do not re-lever their portfolio, dividend cuts will continue), the Annaly's Series A preferred shares are a viable option for income sustainability. They can also be used to complement the shares where total exposure to the name takes place with both common and preferred shares. Either way, it makes sense to look at NLY-A as a portfolio holding.

Source: Annaly Capital - Check Out The Preferreds