Amazing Benefits for this mRIET

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

During a large part of 2012, the spreads that mortgage REITs in general earned were squeezed by the Fed's third round of quantitative easing, also known as QE3. Under QE3, the Fed purchased mortgage-backed securities worth $40 billion every month with an aim to make home borrowing cheaper. This aggressive buying of MBS increased the demand, increasing their prices as a result. Increased prices of these MBS resulted in decreased yields. As a result of QE3, Annaly Capital (NYSE: NLY) reported an over-50-basis-points sequential decline in its net interest spread in Q3.

However, I believe the situation is beginning to reverse largely due to an improvement in the US labor markets. The US unemployment rate decreased from 8.5% in the prior month to the current rate of 7.8%. The economy also added around 155,000 jobs. These improvements in the US labor market are one of the reasons for a 15% week over week hike in mortgage application demand, causing mortgage rates to edge up. The 30-year mortgage rates climbed 6 basis points in January alone to 3.40%. The 15-year fixed rate surged 2 basis points, while the 10–2 year treasury spread has widened 10 basis points since the beginning of the year.

I believe the surge in mortgage rates and the widening of spreads will be an advantage for Annaly.

Additionally, the new Consumer Financial Protection Bureau’s (CFPB) lending rules could help the agency mortgage sector rebound by providing support to the under-pressure mortgage rates.

The new rules are aimed at requiring mortgage lenders to consider borrower’s ability to repay loans before extending credit. A summary of the rules is here. Following are the highlights.

  • The borrower's debt-to-income ratio cannot be more than 43% to qualify for an FHA loan.
  • Interest-only and balloon payment feature are not allowed for qualified loans.
  • There is a 3.5% cap on loan origination fees.
  • Complying banks will be shielded from future litigation.

The demand for these "premium" loans will increase because they have less default risk. That demand will stabilize mortgage rates, returning profit stability to the mortgage REIT sector -- and in particular Annaly Capital.

The business

Annaly Capital Management seeks to invest in and manage residential mortgage backed securities guaranteed by government-sponsored agencies. The goal is to generate net income for distribution to its shareholders from the spread between the interest income on its interest-earning assets and the cost of borrowing on its interest-bearing liabilities. The company’s charter allows management to invest 75% of the total assets in high-quality mortgage backed securities, while the rest can be invested in other qualified REIT real estate assets with at least an investment-grade rating.

Similarly, American Capital Agency (NASDAQ: AGNC) and Armour Residential (NYSE: ARR) seek to invest in agency residential mortgage backed securities with low balances and low coupon rates with prepayment protected characteristics. The conditional prepayment rates (CPRs) reported by AGNC and ARR at the end of the third quarter are 12% and 13%, respectively. Armour Residential’s charter allows the management to own and invest in non-agency residential mortgage securities as and when situation warrants. Therefore, Armour has the room to include high-yielding non-agency MBS in order to navigate an ultra-low mortgage rate environment.

Elevated shareholder distributions

Annaly’s stock offers a double-digit dividend yield of 12.3% when 10-year treasuries are offering 1.89%. The company’s operating cash flow yield (TTM) of around 40% suggests that the dividend distribution is sustainable. Therefore, this elevated shareholder distribution is an added advantage that Annaly Capital’s stock offers to income-focused investors.

The dividend yields for American Capital Agency and Armour Residential are 16.1% and 14%, respectively. American Capital Agency offers an operating cash flow yield (TTM) of 19%.

Valuations

Annaly Capital is currently trading at 12% discount to its third quarter book value, while its closest competitor American Capital Agency is trading at 5% discount to its book value. Armour Residential and MFA Financial are trading at 13% and 2%, respectively. The relative valuations reveal that Annaly Capital is one of the most attractively valued agency mortgage REITs at this time.

Analysts covering the stock have a consensus mean price target of $15.29, while the high target for Annaly Capital is $19.0. The company’s stock is currently exchanging hands at $14.67 per share. Therefore, I believe investors can expect at least 5% capital appreciation on their investments in Annaly Capital. According to the consensus mean price targets for American Capital Agency and Armour Residential, both offer an upside of 10% and 12.5%, respectively.

Conclusion

Given the increase in mortgage rates, widening of spreads, and the new guidelines from Consumer Financial Protection Bureau, I upgrade Annaly Capital Management from neutral to buy. The stock is attractively valued which is why I recommend investors buy the stock and benefit from both capital appreciation and elevated dividend yield. I am already bullish on American Capital Agency and Armour Residential as they are invested in prepayment protected MBS portfolios and offer impressive capital appreciation and high dividend yields.


SmartEquity has no position in any stocks mentioned. 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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