Trading Annaly on QE3 Pressures

Douglas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As with any investment vehicle that is tied to the fixed income market, the forces that impact Annaly Capital Management (NYSE: NLY) are often complex and contradictory. The most basic relationship in fixed income is the inverse one that exists between yield and price: When prices rise, yields fall and vice versa, which means that timing is of critical importance in the construction of a fixed income portfolio. Because it is a mortgage real estate investment trust (mREIT), these forces directly impact the value of Annaly’s portfolio. It is this value, and any changes thereto, that drive the company’s ability to offer a strong dividend yield as it currently does at 12.1%. The impact of QE3 on portfolios like this one is a critical part of evaluating the strength of the underlying stock.

mREITs and Bond Basics

As the largest player in the space, Annaly has long been considered a standard-bearer for the mREIT industry, even as others like American Capital Agency (NASDAQ: AGNC) and Chimera Investment (NYSE: CIM) offer higher dividend yields at 142% and 13.2% respectively. The basic model followed by each of these mREITs is to borrow capital in the short-term market, typically in the repo market, and then use that capital to purchase higher-yielding mortgage backed securities (MBS). This model works best when the spread between short-term rates and MBS is high.

Where things become complex is that favorable conditions for existing investments and for the initiation of new positions are not the same. Once you own the MBS, you benefit from increases in prices to those instruments because they can be sold at a profit; this occurs when a determination is made that the capital gains available will outpace the return available from holding the higher yielding instruments. There is, however, a significant difference in the duration of the source of funds and the duration of the use of funds – the borrowed capital is regularly rolled because the term of the loan is shorter than the term of the MBS that was purchased. This means that as rates fall, you can borrow at increasingly low rates, expanding the spread because the MBS in question maintain their yield.

On the other hand, as rates fall or remain low, the spread between short-term capital and the yield available on new purchases of MBS tends to contract. This is a direct function of the multiplier effect of the longer duration carried by the MBS. Essentially, while your existing MBS are becoming more expensive – and, therefore, yielding less – you are able to secure smaller and smaller spreads on new investments. Under normal conditions, there is sufficient fluctuation that experts can regularly create effective portfolios. When rates remain artificially low indefinitely, however, this becomes more problematic.

The Impact of Quantitative Easing

During previous rounds of quantitative easing, the Federal Reserve's decision to keep rates low while purchasing longer-term bonds was negative for mREITs. It put pressure on the interest rate spread by pushing down longer-term rates more than shorter-term rates. This phenomenon is compounded under QE3 because the Fed is now specifically buying agency MBS. This means that there is significant demand for the bonds that Annaly, American Agency and Chimera already own, but the rates available on new purchases is under intense pressure. While these companies will be able to offset some of these lower spreads by realizing some capital gains on the bonds they already own, this must be balanced against the reality that they will not likely be able to replace the MBS they already own at similar yields.

The Reaction in the Market

The forces above account for the Morgan Stanley's recent downgrade of Annaly, in which it stated its preference for hybrid mREITs over agency mREITs: “We prefer hybrids to agency mREITs at this point in the cycle on 1) higher yields as non-agency prepayments are likely to increase (non-agency MBS is carried at a discount), and 2) future portfolio growth in higher yield assets as non-agency originations begin to increase from today’s very low levels.” Morgan Stanley upgraded hybrid mREIT Invesco Mortgage Capital (NYSE: IVR). Invesco has less exposure to the agency MBS that are the target of QE3.

Trading Annaly

What all of the above means is that Annaly’s dividend is likely to come under pressure in the coming quarters unless there is a significant shift in the tenor of the economy. There is clearly a significant cushion when you are starting at a double-digit yield, but the potential for contraction is significant. As such, one’s investment horizon is a critical element. As a shorter or medium-term investment, there is still good potential in Annaly, but as a longer-term option, there may be better choices and care is required.

Know What You Own

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 pitfalls of their strategy. Click here now to claim your copy.

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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