Annaly Gets Implied Fed Blessing

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While the Federal Reserve is not in the business of endorsing particular stocks, its announcement of the latest round of quantitative easing is an implied endorsement for Annaly Capital Management ) and other mortgage real estate investment trusts (mREITs). The structure of the Fed’s current policy initiative, as well as its long-term target for interest rates, is ideally suited for mREITs because it both helps demand and the supply of capital with which to buy securities. Offering significant income to shareholders and creating unrivaled yields even on a risk-adjusted basis mREITs are a solid additional to your core portfolio.

The mREIT Model

The basic goal of an mREIT is to generate income by earning the spread between the interest rate received on the mortgage-backed securities (MBS) held by the company and the rate that must be paid by the company to finance those purchases. In addition to Annaly, major market participants include American Capital Agency ), Two Harbors Investment Corp. (NYSE: TWO) and Capstead Mortgage ); investors can also gain exposure to the sector through the Market Vectors Mortgage REIT Income FUND : MORT). These companies profit primarily by generating consistent income streams, but also by increasing the book value of their portfolios.

The Role of QE3

Under the recently announced plan by the Federal Reserve to begin a new round of quantitative easing, the Fed will buy $40 billion of mortgage-backed bonds each month. This move, targeted in the agency sector in which Annaly specializes, will increase demand for agency MBS. This is likely to drive the prices of those securities held in Annaly’s portfolio higher. Increased book value of the portfolio is favorable for the company.

On the other side of the equation, the Fed committed to keep rates low until mid-2015. This extended the originally announced low-rate duration by a full year. What this means for Annaly is that its financing costs should remain relatively low for the next three years. The joint effect, therefore, of this round of QE is that the company is helped on both the supply and demand side of its business. The Fed may not have intended to give its tacit endorsement of a particularly industry, but the net effects have that impact on mREITs.

The Dividend Picture

The result of the mREIT business model is that the bulk of profits are distributed to shareholders through the dividend. In Annaly’s case, the company currently offers a dividend yield of 12.7%. This compares favorably to its peers: American Capital Agency is at 13.7%, Capstead is at 10% and Two Harbors is at 12.1%. While these yields are far more volatile than those for typical large cap stocks,in a yield environment in which U.S. Treasuries offer less than 2%, these numbers are hard to beat.

A Better Option

While Annaly has been the veritable standard-bearer for the mREIT industry, American Capital Agency is actually more attractive at current levels. This is not to say that Annaly does not have plenty of appeal, as well as the implied Fed endorsement discussed above. Rather, if Annaly is the shiny object in the store front that brings you in the door, American Capital Agency is the stock that you leave the store with. On a relative basis, Annaly is trading at a P/E of 54.5 relative to 10.2 for American Cap. Two Harbors and Capstead are more in line with American Cap, but with market capitalizations nearly $9 billion smaller, Annaly and American Cap make a better direct comparison.

In addition to the P/E differential, American Capital has a more attractive profit margin; 88% relative to 51% for Annaly over the past year. Operating margins are disproportionately in favor of American Cap as well at 88% relative to 60% for Annaly. Overall, the metrics stack up in favor of American Capital, although most companies in the sector are well positioned at current levels.

Trading mREITs

While there is certainly a real level of risk involved with these names, the available yield seems to justify that risk. It is not often that a group of companies are so well positioned to directly take advantage of Fed policy, but this is the case here. While Annaly remains the big name in the market, America Capital Agency is the name to choose if you are picking a single name to which to commit capital. The stock looks attractive at current levels and should be considered a buy.

Dig Deeper

Annaly Capital Management has a history of paying huge dividends to shareholders, made
possible by borrowing at cheap short term rates and investing in longer term mortgage
securities. But there are some things investors absolutely must know about Annaly’s business
before buying the stock. In this brand new premium research report on the company, a Fool
analyst runs through the dynamics of Annaly’s business, as well as the future opportunities and
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Mr. Ehrman has no positions in the stocks mentioned above. The Motley Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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