Is there a safe but potentially rewarding play with Annaly Capital and mREITs?
The short answer is yes. NLY and all mREITs have been hammered lately and multiple articles here on Seeking Alpha have documented the real and perceived problems with mREITs, so using mREITs and safe in the same sentence seems counter intuitive, but hear me out. NLY and other mREITs are designed for high yield (yields significantly above 10-year treasury notes and other benchmarks) and should be held for that purpose and not capital appreciation. However given the recent rundown in share value, buying the stock for capital appreciation could be rewarding.
I favor using a structured product approach and hedging the position with options. Essentially using the dividend money to buy puts and protect the principal. Table 1 below illustrates the trades using REM (mREIT ETF), NLY, and AGNC as examples, but of course other mREITs can be used.
Table 1: Based on closing prices from 6/7/2013.
To best explain the table let's go over the first row in order from left to right: Share purchase price, put purchase price, put strike price, call sale price, call strike price, # of dividends, dividend, max. loss in $ and % if shares are below put strike price at maturity, gain if there is no change in share price in $, %, and % annualized, gain in $,%, and % annualized if share prices increases ½ way to 52 week high.
The last three columns in green show the potential returns if the stock price were to retrace ½ of its drop from the 52 week high. Using this approach, REM, NLY, AGNC could return significant gains with limited risk assuming the share price recovers some between now and Jan 18, 2014.
Last year NLY and other mREITs suffered an even bigger drop driven mainly by QE3 tightening the spread between long and short term rate (See figure 1).
Figure 1 from Yahoo finance charts.
The chatter around that time was that mREIT business model was not sustainable, everyone should sell their mREITs, etc. NLY in response lowered the dividend and adjusted its business model to address the tightening spread by acquiring CXS. The share price recovered to $16 or roughly half of the drop. The drop this time is due to the tapering of QE3 and the projected increase in interest rates decreasing the book value of mREITs. I expect the price per share to similarly recover as the interest rate picture becomes clearer and the spread between the short and long term interest increases with the tapering of QE3.
I hold similarly structured positions in NLY and REM. I recommend selling the calls on any share price spikes to maximize return. I also might or might not hold the positions until maturity to maximize returns, and example would be selling the puts once the interest picture become clearer and the outlook for the mREIT sector improves