There are a lot of discussions about dangers of investing in mREITs such as Annaly Capital Management (NLY). Many of these discussions focus on the fact that U.S. Federal Reserve might increase short term interest rates starting 2014, and that this company's profits will suffer seriously if/when that happens. According to this point of view, not only the company's profits, but also investors' dividends will suffer the same fate. It may or may not be true, but I believe in conservative investment, and I always take precautions to make sure I preserve my capital before thinking about profits.
Annaly's dividend yield of 13% is really nice. When one considers the fact that stock market's historical average annual returns are about 10%, and that many fund managers fail to even get that kind of return, 13% annual return looks even better. I would assume that if the dividend rate was to fall significantly starting 2014, the stock price of the company would be pushed down as a result, because many dividend investors might sell this stock and look for other avenues of income. Again, this may or may not happen. I would rather be on the safe side and be prepared for the worst case scenario. Then how do you do that? After all, once you buy a stock, you have almost no control over what the stock will do. It may go up, it may go down, it may stay flat, it may do all kinds of things.
One way to have at least relative control over price of one's stocks is to write options and enjoy the premiums. Many people consider options very risky, however, it is only true if you are the one buying the options, not the one selling them. Let's look at Annaly Capital's call options expiring in January 2014 in order to see how much protection it offers investors in case short term interest rates increase and Annaly's profits suffer. The current share price for Annaly's is $16.00. If we are looking at writing a call with a strike price of $10.00, we will get a premium of $6.00. This is a bad deal as it doesn't offer any value for the time. If we set a strike price at $13.00, we are looking at a premium of $4.50. If by January 2014, Annaly's share price plunges below $13.00, we will get to keep the stocks in addition to $4.50 premium. If we bought the stock at $16.00, the premium offers protection until the stock plunges below $11.50. This means, unless the stock price plunges below $11.50, in other words near 30%, you will be making profit. In fact, all the dividends you collect during this time will add up to your profit. If Annaly keeps its dividend rate steady, you are looking at a yield of 20% or so by January 2014. If the stock price remains above $13.00, you won't lose much as you will have collected all the dividends plus $1.50 of the premium, however you will not be able to keep your stocks. You are still looking at a solid return and most likely beating the market.
If the stock price goes above $17.5 during this time, you will miss out on extra profits, but given the dividends and the premium, I wouldn't be too worried about that. Depending on your risk appetite, you can set the strike price higher or lower, but I definitely recommend selling calls on the stocks you own in order to maximize the income potential and protect yourself from any possible downturn. Because Annaly is not a very volatile stock, the short term option plays will not be very profitable and the commissions (along with taxes) will eat up most of your profits. This is a play I do not recommend. If the short term interest rates remain low after January 2014 and you still own the stocks, you can write another call to extend your gains even further.
Disclaimer: Option premiums can fluctuate just like stock prices do. The numbers mentioned in this article might be different from what you see by the time you read this article. Please make sure to keep your risk appetite on mind while picking a strike price.
Disclosure: I am long (NLY)