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How Will Annaly React To Fiscal Cliff Agreement?

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

Americans are mixed on the "fiscal cliff" agreement reached by Congress and signed into law by President Barack Obama. 43% of Americans approve of the decision that was agreed upon, while 45% disapprove of the decision. The fiscal cliff agreement will dissolve some, but not all, of the negative economic impacts of going over the cliff. Most importantly, the agreement will extend the Bush-era tax cuts for the vast majority of Americans.

The agreement specifies that the capital gains on individuals earning less than $400,000 and households earning less than $450,000 will remain at 15%. The rate for those earning above this threshold will jump to 20%. Dividends will continue to be taxed at the current capital gains rate. In this article, I will explain how the fiscal cliff agreement will make mREITs like Annaly (NYSE: NLY) and its peers more attractive for investment.

Will Annaly Sustain Its Dividend?

Annaly cut its dividend by 10% to $0.45 per share for the fourth quarter. It was the second cut this year, down from $0.55 per share several quarters ago. Nevertheless, the dividend yield is still attractive at 12.8%. Annaly has already reported a decline in the third quarter of over 1% in its net interest margin year-over-year. Lower MBS issuance, record low mortgage rates, and accelerated prepayments during 2013 will continue to erode the net interest margin because the company invests mostly in Agency MBS. Increased purchases of MBS by the Federal Reserve and continued low interest rates will continue to negatively impact pure play mortgage REITs like Annaly. Mortgage rates have already reached their lowest levels in history. The 30-year rate is at 3.32%, while the 15-year rate has plunged to 2.66%.

Annaly is the largest agency mREIT on the market today. Annaly has demonstrated its ability to outperform the market. Its bid to buy CreXus (CXS) and diversify into commercial real estate from residential mortgages has not yet been finalized, nor has there been any progress regarding the buyout of Chimera (CIM).

Management still has some time to tweak its business model and explore other avenues in order to boost its future prospects. Management has already noted it may allocate up to 25% of the approximately $17 billion shareholders' equity to real estate assets other than Agency mortgage-backed securities. The allocation as of the third quarter of 2012 stands around 6%. This will raise earnings, but also heighten the risk of the investment portfolio.

Annaly – Fourth Quarter

Under the latest plans for the fourth quarter, in addition to purchasing $40 billion worth of mortgage backed securities every month, the Federal Reserve is going to purchase another $45 billion each month in Treasuries. The Federal Reserve has decided to keep federal fund rates at between 0% and 0.25%, and is committed to keeping these exceptionally low rates as long as the unemployment rate remains above 6.5%. Inflation is predicted to be no more than 0.5% over the 2% long-term goal. The silver lining for Annaly is that there has been no increase in the Federal Reserve target for buying mortgage backed securities. However, the Federal Reserve will continue putting pressure on MBS yields and the net interest margin, and this may translate into decreased dividends.

Other mREIT Dividends

In an increasingly difficult environment, many pure-play Agency mREITs have slashed dividend payouts. Capstead Mortgage (NYSE: CMO) slashed its latest dividend to $0.30 from $0.36 last quarter. Capstead currently has a dividend yield of 10.5%. Hatteras Financial (NYSE: HTS) cut its dividend from $0.80 to $0.70 over one quarter. Hatteras currently has a dividend yield of 11.3%. Armour Residential (NYSE: ARR) cut its dividend to $0.08 from its previous level of $0.09. Armour currently offers a dividend yield of 14.3%.

Both American Capital Agency (AGNC) and Anworth Mortgage (ANH) were able to maintain their dividend payments. Things have been a little better for mREITs, which also invest in non-agency mortgage backed securities. New York Mortgage (NYMT) and Invesco Mortgage (IVR) have also been able to maintain their dividends. The problem with Agency mREITs is that the only way in which they can maintain dividends is by selling mortgage backed securities. But this is a short-term fix, because they would be forced to replace these investments with lower yielding securities.

Conclusion

Annaly shares are trading close to 52-week lows following several downgrades recently, though I do not believe that there is much more downside to the price. One of the analysts, Gary Gordon of Portales Partners, says he would probably raise his recommendation once the stock goes lower than the current price of around $14. The current price of around $14.84 is still below the book value of over $16, and the book value is based on market prices. The full value would be received in the event of a sale of securities. The same analyst said that even if the company is forced to slash its dividend further, he believes that the dividend yield will not drop below 8%. Moreover, there is scope for some capital appreciation because analysts have an average target price of around $15.40.

The Federal Reserve has clearly outlined its future policy and targets, which makes it much easier to monitor mREIT investments and take advantage of the attractive dividend yields. I recommend buying Annaly as an income investment.


jordobivona 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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