11.5% Yields Don't Come From Banks; Don't Throw Annaly Away

Summary

  • The real estate sector was separated from financials, but mortgage REITs didn't go with real estate.
  • The financial sector is fundamentally different from mortgage REITs, and they should not be lumped together.
  • Short-term correlation between Annaly and the financial sector shows investors trading on emotion rather than fundamentals.
  • NLY-E remains very attractive at $25.31.

Annaly Capital Management (NYSE:NYSE:NLY) is a mortgage REIT. Officially, that means NLY is part of the "Financial" sector. Even though a new sector was carved out for equity REITs, the mortgage REITs remain stuck in the financial sector. See the statement from MSCI below:

The problem is that the financial sector doesn't have much in common with the mortgage REITs. Sure, banks loan out money. Is that really all it takes to be fall into the financial sector? Banks could earn more interest income on their excess reserves if the short-term rates were increased. The mortgage REITs would stand to see a higher cost of funds that would squeeze their net interest spreads. That sounds like they have pretty much the opposite desires for action (or inaction) from the Federal Reserve.

That begs the question, why does Annaly Capital Management have any correlation with the financial sector? I used the Financial Select Sector SPDR ETF (NYSEARCA:XLF) as my proxy for the sector, and I included CYS Investments (NYSE:CYS) to demonstrate that it happens to other mortgage REITs as well:

Annaly Capital Management is the red line in that chart. You may notice that it demonstrates a significant correlation to the financial sector. That shouldn't hold up over the longer periods, but the short-term correlations should be enough to concern investors.

Things That Matter to Mortgage REITs

One thing that really matters to the mortgage REITs is their cost of funds. Most mortgage REITs use large positions in LIBOR swaps to reduce their exposure to a fluctuation in interest rates, but they are still exposed to the risk of paying higher costs on their "repo agreements". Those repo agreements are primarily how the mREITs finance their leveraged portfolios. If short-term rates increase, those costs move higher. An increase in those rates could put dividends in jeopardy. So far, I expect

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Disclosure: I am/we are long NLY-E. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.
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