Rising Interest Rates Present Buying Opportunity For Annaly Capital And Other Mortgage REITs

| About: Annaly Capital (NLY)
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We've recently seen an uptrend in the yields of the 10-year treasury bonds, as investors move their money to riskier propositions like stocks.

(Click charts to enlarge)

This is not unexpected. Treasury rates have been at record lows for quite some time. This has been partly caused by fear over the European Sovereign debt crisis and the U.S. economy in general and partly by easing measures from the U.S. Federal Reserve. Since current yields have been at record lows, eventually the opposite outcome should surface, as long-term yields return to normal along with the recovery of world economies, which is quite possibly what you are seeing now. Many investors such as Warren Buffett and Bill Gross have stayed away from long-term treasury bonds for this reason, postulating that long-term rates have nowhere to go but up!

While the outlook for treasury bonds looks dim to myself and others, there is a great way to profit off this, and one especially that has presented itself recently. These are in the always popular Mortgage REITs sector.

Mortgage REITs are Investment Trusts that invest in Mortgage Backed Securities. These stock investments are essentially similar to buying bond funds. The earnings are generated by buying, selling and collect coupons off bonds. Their payouts are quite high, since as REITs they are not taxed by the government if they distribute 90% of their earnings; however, as part of the trust, you are then taxed at normal income tax rates.

Despite the dirty sounding name hailing from the 2008 financial meltdown, Mortgage Backed Securities can be excellent investments. They are bonds mostly issued by Fannie Mae (OTCQB:FNMA) or Freddie Mac (OTCQB:FMCC) [essentially the U.S. Government at this point] that parcel out the mortgages that they have purchased to other investors. This allows these entities to keep lending and spread the risk around to others.

As long-term treasury rates rise, so will mortgage rates, as they are essentially tied to long-term treasuries. Sure, the Federal Reserve may step in occasionally to knock down the spread between the two, but in the slightly longer term, mortgage and long-term treasury rates will be headed up. Remember though that the Federal Reserve has pledged to keep short-term interest rates low until 2014, and that rate they have full control over. This results in a steepening of the "yield curve" and a higher difference (spread) between short-term rates and long-term rates.

This steep yield curve situation is an ideal one for Mortgage REITs. After purchasing MBS with the company's capital, they leverages those bonds, borrowing against them. Since they borrow short and buy long, they then collect the difference between the two rates. The greater the spread, the more money they make!

The leverage is how they can turn a 2% spread into a yield over 10%. This allows them to make more money, but opens up greater risk, because the more leverage one has, the greater the magnification of gains and losses. Too much of this behavior is what bankrupted Bear Stearns for instance. Most Mortgage REITs use far less leverage than Bear Stearns did, however investors must remember that anything involving leverage brings on additional risk. Factor this accordingly into your asset allocation.

There are many popular choices in this sector, including Agency (NASDAQ:AGNC), Hatteras (NYSE:HTS), Capstead (NYSE:CMO), Chimera (NYSE:CIM) [which focuses more on private MBS], and all of them will benefit from this atmosphere. However, I see a special opportunity in one of the best of these Mortgage REITs, and that is Annaly (NYSE:NLY).

Annaly is a leader in the field of Mortgage REITs and invests in the MBS of so-called GSEs or Government Sponsored Entities like FNMA. These are much safer than private MBS, as at this point, it appears the full weight of the powerful U.S. government is squarely behind them. Annaly is also well known as one of the most adept at buying, selling and leveraging MBS, and their CEO Mike Farrell is very well respected in the MBS arena.

However, looking at the stock chart, you'll notice the rally has left it behind.

You'll see that during the big rally since October of last year, the S&P 500 (NYSEARCA:SPY) is up about 20%, but NLY is only up 2%. As an example, fellow Mortage REITs CIM and AGNC are up about 9% (not counting a healthy dividend payout)

Why is this? First there have been some concerns over Mike Farrell's health. In late January, he announced he was diagnosed with cancer, but said it was detected early and treatable. Secondly, there have been some concerns that it is underleveraged and this could hurt payouts.

Now I can't speak to the cancer. Losing Farrell would not only be a personal tragedy but would be a big loss to the company. He says it is treatable, and that's a good sign. However, as to the leverage, I think the market is missing what's going on here. While I'll be the first to admit that I am no fixed income expert, it seems to me that by keeping the leverage low, Farrell is basically "selling at the top" and saving valuable leverage ammunition to buy higher-yielding bonds later. Why leverage to prop up yields only to see the value of the bonds decline as interest rates rise? And as I see it, he knows what he's doing, so I'll trust him to know the leverage metrics of his company. I believe he'll add leverage when appropriate.

This is a great opportunity to invest in Mortage REITs, as they are encountering some very favorable circumstances in the form of low short-term interest rates and higher long-term interest rates. Additionally, Annaly, one of the highest-quality Mortgage REITs, is a bargain right now, being punished for its current lower returns when in fact, it is showing appropriate prudence with its bonds purchases.

Disclosure: I am long CIM.

Additional disclosure: May initiate a new position in NLY shortly.