How Secure Are Annaly's Mortgage-Backed Securities?

Jul.15.12 | About: Annaly Capital (NLY)

Annaly Capital Management (NYSE:NLY) operates as a REIT with a $16.42 billion market cap. It owns and manages a portfolio of mortgage-backed securities. The REIT primarily makes its money by profiting from the spread between the interest income on its mortgage-backed securities and the costs of borrowing to finance its acquisition of mortgage-backed securities. It also profits from dividends that it receives from its subsidiaries, which are taxable REITs.

The REIT has a generous dividend yield of 13.1%. Since many investors are lured to Annaly for this high yield it is important to know how secure these mortgage-backed securities are. The success of the REIT and its high yield depends on the strength of what it owns.

Annaly's investment policy states that at least 75% of its assets must be comprised of high-quality mortgage-backed securities and short-term investments. High-quality securities means one of three things:

  1. Securities that are rated within one of the two highest rating categories by at least one of the nationally recognized rating agencies.
  2. Securities that are unrated but are guaranteed by the United States government or an agency of the U.S. government.
  3. Securities that are unrated but are determined to be of comparable quality to high-quality rated mortgage-backed securities.

Under Annaly's policy, the remaining 25% of its assets may consist of other qualified REIT assets which are at least investment grade (rated BBB or higher by S&P or another nationally recognized rating agency. Annaly also allows investments in unrated debt, equity or derivative securities which are a part of this remaining 25%.

As of March 31, 2012, all of Annaly's mortgage-backed securities were backed by single-family mortgage loans. All of these securities were Freddie Mac, Fannie Mae, or Ginnie Mae pass-through certificates or CMOs which carry an actual or implied AAA rating.

This should put investors' minds at ease as Annaly strives to maintain a high-quality asset composition.

Annaly's primary market risk is its exposure to interest rates. The following table shows how changes in interest rates affect changes in the REIT's net interest income and changes in portfolio value.

Changes in Interest Rate

Projected % Change in Net Interest Income

Projected % Change in Portfolio Value w/ Effect of Interest Rate Swaps

- 75 basis points

7.01%

0.96%

- 50 basis points

4.78%

0.69%

- 25 basis points

2.11%

0.39%

+ 25 basis points

(0.48%)

(0.49%)

+ 50 basis points

(2.05%)

(1.07%)

+ 75 basis points

(4.17%)

(1.75%)

Click to enlarge

Since the current interest rate environment is favorable for Annaly, the REIT should perform well. With the current uncertainties in the U.S. and world economies, interest rates should remain low and favorable until inflation heats up to the point where interest rates need to be raised. Inflation at that level may not happen for a few years. So, Annaly should perform well during this time.

Annaly looks nicely undervalued as it is trading at only 1.04 times its net asset value per share. It has a solid operating cash flow $2.4 billion. Overall, this REIT looks like a generous income producer with fairly secure assets for those who wish to put some money to work.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.