Owning Annaly Capital With A Margin Of Safety

Apr. 3.12 | About: Annaly Capital (NLY)

Throughout 2010 and 2011 Mortgage REITs, especially Annaly Capital (NLY), performed extremely well compared to stocks in the broader market. The company's larger than life dividends and steadily increasing performance has drawn a lot of attention to this sector. One of the main reasons for the outperformance that has been seen in this sector is due to the low interest rate environment that we are currently in.

Annaly Capital makes money by trading the interest rate spread that exists between the short and long term bonds of securitized mortgages. These types of bonds are backed by government entities like Fannie (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), which help give these types of investments a lower risk rating simply due to the notion that the government most likely will not let them fail.

Annaly, like other mREITs, uses large amounts of leverage that enable the company to capitalize on the spread between the long and short term interest rates. Annaly's taxation is a bit different than most publicly traded companies because of their mREIT status. Annaly is taxed as a trust and is obligated to pay a majority of their earnings to their shareholders in dividends, hence the large dividend rate.

I have read a lot of articles about this company and there always seems to be a lot of concern about the company's overall stability, high dividend rate, and the amount of leverage the firm takes on in its day-to-day operations. I, on the other hand, am not as concerned even after this past quarter's earnings report. Annaly has been anticipating the narrowing of interest rate spreads in the coming months and has been proactively decreasing the overall exposure and leverage ratio, which should help decrease their overall risk.

Unfortunately, because of this de-risking its overall revenue is bound to take a hit which in turn will negatively affect the dividend rate. As a shareholder I believe this is the responsible and prudent approach that will ensure the company stays in business and the stock price remains somewhat stable.

Annaly has several competitors in the market that all do essentially the same thing and pay comparable dividends. The chart below shows a comparison of Annaly's competitors and how their book values and dividend rates stack up.

Current Price

52 Wk High

Book Value

Dividend Value

Annaly Capital

$15.82

$18.79

$16.27

13.86%

American Capital Agency Corp (AGNC)

$29.90

$31.17

$27.71

16.72%

Capstead Mortgage Corp (CMO)

$13.20

$13.95

$14.64

13.03%

Redwood Trust Inc. (RWT)

$11.60

$15.93

$12.27

8.62%

MFA Financial (MFA)

$7.35

$8.35

$7.01

13.06%

Click to enlarge

Since the biggest risk that companies like Annaly face is interest rate spread contraction which has affected their overall dividend payouts, and share prices taking a bit of a hit from their recent highs. On the bright side, the Federal Reserve's promise to keep interest rates at historic lows until 2014 should help the mREIT space's revenue for the next couple of years, but nothing is ever a guarantee. As the U.S. economy continues to recover it is only a matter of time before interest rates begin to go back up and further pressure is put on these mREITs.

Annaly's most recent quarter reflected the negative effects of these interest rate changes and de-risking activities. Annaly posted a net income of $445 million which was a decrease from the year prior of $1.218 billion. This decrease affected the dividend payout, which was decreased for the quarter to $0.55/share compared to the $0.64/share the year prior. Annaly's book value did increase to $16.27/share compared to the year prior's book value of $15.68/share.

With the above information being the case I find it to be a prudent approach to hedge my mREIT position a bit, in the event of any unforeseen negative price swings. In most situations like these I usually like to execute an option collar on my trade. This is where the trader sells call options on their position and uses the premium collected from the calls to buy puts. This strategy limits the traders upside potential, but it also provides downward protection with the put. Unfortunately, the pricing of Annaly's calls and puts does not always allow for this type of trade to make much financial sense.

Instead what I prefer to do is a bit of a modified collar. I like to still sell a call against my position at the strike price above or at (depending on pricing) of my purchase price. I then buy a put at a protection level that I am comfortable with; this is the typical collar approach. What is different is I then sell a put at the strike below the strike of the put that I purchased. This strategy provides two option premiums (1 from the call and 1 from the put that was sold) that help offset the cost of the protective put.

This strategy provides downside protection for the trader's current long position as well as provides the trader with a new and cheaper entry position. As a disclaimer, I would only recommend this strategy on a stock where the trader likes the potential of buying the stock again at the strike price where the put option was sold at, since the put option that was sold is not hedged and the trader might be obligated to by the stock at the price. I currently like the July options on Annaly. With the stock currently trading at $15.82/share I would suggest selling the $17 call for $.06/share, buying the $16 put for $.80/share, and finally selling the $15 put for $.37/share.

This trade would result in a total debit to the trader of $.37/share, a potential stock appreciation of $1.18/share, and a total downside of $0/share. Keep in mind that the $16 put allows the trader to sell their stock at $16/share with an initial purchase price of $15.82, hence the $0 downside on the $15.82/share cost. This trade can be done with any number of puts/calls at various strikes depending on how bullish/bearish the trader is feeling about the stock. Being that I am more bullish I have my strikes more spread out then I normally would if I were bearish.

With the July contract being chosen for this trade it allows the trader to continue to capitalize on the dividends while still having some protection from any unforeseen interest rate adjustments. This is a fairly prudent approach that works well, especially for those that want to take advantage of the dividend payments.

Disclosure: I am long NLY.