Annaly's 12.9% Yield - Not Going Away Soon
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Mortgage REITs like Annaly Capital Management (NYSE: NLY) have many things in common. They invest in the same product, mortgage backed securities, they have to distribute 90% of their earnings to preserve their tax-exempt status, and they use leverage to magnify their interest spreads. However, you should not make the mistake of thinking that they are identical in the way in which they operate and the investment strategies they implement. For instance, REITs like Annaly or American Capital Agency (NASDAQ: AGNC) have a charter to invest only in mortgage backed pass-through securities that are backed by government agencies and therefore relatively lower risk. On the other hand, a REIT like Chimera (NYSE: CIM) has substantial investments in non-agency mortgage backed securities, which are much higher risk and should be seen as the equivalent of junk bonds. This is why you would approach an investment in Annaly completely differently from the way in which you would consider an investment in Chimera.
In these difficult times, you are naturally trying to generate the maximum possible income from your investments, and stocks with high dividend yields have been in the limelight. Mortgage REITs have become popular because these companies make their money from highly leveraged bets on the yields from long-term mortgage-backed securities and have to have payouts of at least 90% to retain their tax exemption. Some investors make the mistake of going by the dividend yield alone, but you have to be aware of some of the risks associated with investing in mortgage REITs. They invest in mortgage backed securities, whether agency or non-agency, and the yields are possible because they borrow large amounts of money at short-term interest rates with these securities as collateral, while the return from the long-term securities is higher. The proceeds of the loans are then reinvested in more mortgage-backed securities and so on. As a result, these companies are permanently hungry for capital and will raise money at every favorable opportunity even though it may not be in the best interest of existing shareholders.
Take the case of CYS Securities, which announced a secondary offering of 40 million shares and is looking to raise around $600 million if the underwriters exercise all their options. For existing shareholders, the negative aspect of the offering is that it is priced at around 3% below the prices at which shares traded before the offering. In other words, investors buying the secondary offering got a better deal than they would have done if they had bought shares in the open markets. Despite this being an unfair deal to the existing shareholders, you can hardly blame the company for taking the opportunity to raise a large sum of money on relatively attractive terms.
Annaly is now the largest mortgage REIT in the United States and has reported net income of $901 million and earnings per share of $.93 a share for the first quarter of the current fiscal year. In May, the company issued convertible notes yielding 5% worth $750 million to augment its financial resources and increased its portfolio of mortgage backed securities. The present dividend yield is 12.9%.
In view of the slow recovery of the US economy, the Federal Reserve has continued an easy money policy and has kept short-term interest rates close to zero, which is expected to continue into 2014. This works to the benefit of REITs like Annaly by protecting their interest rate spread (the difference between long-term yields earned and short-term borrowing costs, which represents their profit margin) and investors will be benefited as well. From an investor's point of view, this means that the current dividend yield is sustainable and the risk is minimized, because Annaly's portfolio consists largely of mortgage backed securities insured by federal agencies, which can be regarded as implied backing from the US government. Competitors like Impac Mortgage Holdings (IMH), Redwood Trust (RWT), MFA Financials (MFA), Anworth Mortgage Asset (ANH) and Capstead Mortgage (CMO) are also benefiting from the situation. A report from Credit Suisse expects the mortgage REIT industry will continue to provide double-digit returns in 2012 for shareholders.
Mortgage REITs are by no means the ideal income investments for the long-term, but the stance of the Fed means that there is little downside to an investment until at least 2014. All mortgage REITs are not the same, and there must be an element of discrimination in picking your investments. As an example, let us consider two REITs with similar profiles: American Capital Agency and Annaly. American Capital has been successful over the past couple of years and surpassed Annaly in terms of dividend yield by using a greater degree of leverage. But leverage is a two-edged sword and this makes American Capital a riskier investment. By contrast, Annaly has limited both leverage and portfolio risk and is, by the standard of other mortgage REITs, comparatively conservatively managed. The cash it keeps on hand also provides better protection against sudden spikes in interest rates.
You must always keep in mind that REITs are relatively high risk investments, though Annaly is less risky than many of its peers. I recommend that you consider Annaly now and enjoy the benefits of its attractive dividend yield. Keep track of interest rate movements and the Fed's attitude so that, if things get tougher for the mortgage REIT industry and Annaly in particular, you can alter your position ahead of any adverse moves in Annaly's stock price.
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