Looking for Yield? Look No Further

by John Jagerson and Wade Hansen | September 27, 2012 12:47 pm

Recommendation: Buy NLY under $18; if stock dips but remains above $16, buy aggressively.
Options Alternative:
Buy to open the Jan. 2014, 17 Calls for 55 cents or less.

While savvy investors have adapted, the hunt for yield has become uniquely challenging because of how thoroughly the Federal Reserve has reshaped the investing landscape. Looking for respectable yield has become like foraging for fruit in the desert.

As recently as mid-2007, you could have received over 5% from a 10-year Treasury, which now yields 1.64%. Look at other yields in the same ballpark: Italian 10-years are at 5.04% and Spanish 10-year generic notes are around 5.8%. The safest 5% investments in the world just five years ago now require the issuance of the unstable eurozone nations.

And junk bonds? The current average yield on the U.S. Corporate High Yield index is 6.91%. Calling that “high yield” would be the stuff of satire if there was a place for irony in financial markets. In the meantime, 1-year CDs are earning investors a national average of (hold on to your hats) a full 0.3%. Savers have to go out to five years just to earn close to 1%.

Annaly — A Rainshower in the Yield Drought?

In this environment, a company delivering a hearty yield without the uncertainty of the ongoing European tragicomedy — not to mention a business model that benefits from current Fed policy — is precisely what income investors need.

Annaly Capital Management (NYSE:NLY[1]) is the largest mortgage REIT, yielding 12.5% with a market cap of $17.2 billion. NLY manages a portfolio of mortgage-backed securities (MBS) such as mortgage pass-through certificates, collateralized mortgage obligations and agency callable debentures.

A 12.5% yield doesn’t come without risk, of course. Annaly borrows short and lends long — which certainly has its share of risk if interest rates spike. If rates rise, their assets move down in value while duration lengthens. In that scenario, NLY would have to increase its debt-to-equity (i.e. leverage) and the risk its shareholders bear to keep earning what it now earns. Or it would simply earn less.

But no one is more cognizant of these pitfalls than NLY’s management executives — all respected veterans who have learned some lessons in their tenure, especially during the credit crisis. The result is that NLY  paid approximately $1.26 per share to hedge its assets with adjustable- and floating-rate securities as of 2010. Their current debt-to-equity ratio has dropped to 6x, up slightly from 5.8x a year ago, but down substantially from the 10-year average of 9.5x.

Taking Account of the Terrain

So while the Fed has fundamentally altered the terrain, it’s done so in a way that could hardly be better for NLY — especially since NLY invests predominantly in MBS securities from Fannie Mae and Freddie Mac. Those names recall uncharitable memories, but because these agencies can access the Treasury’s vaults via bailouts, the securities they issue are high-quality.

As stated, interest-rate risk is NLY’s most formidable foe. But since Bernanke & Co. intend to keeping rates low and stable, NLY couldn’t ask for a better ally. Perhaps Fed policy will have unintended consequences; perhaps the Fed will be unable to smother market pressures at some point; perhaps inflation will undo the goals the Fed is trying to pursue.

Whatever happens, the Fed has a hold on the market throttle and the market wants to respond accordingly. And as long as the interest rate environment remains low and stable, it will benefit NLY.

Price vs. Dividend

The long-term performance on NLY may not look impressive, with prices almost unchanged since May 2008. Compare this to Simon Property Group (NYSE:SPG[2]), which gained 50% since that time. But NLY has still produced an 80% total return — not far off SPG’s 88% — due to NLY’s 12% yield versus SPG’s 2.6% yield.

While we’re mentioned dividends, it’s also good to note that NLY went “ex-dividend” on Sept. 27th, which means that the stock started trading without the 50 cent dividend that will be paid to shareholders who were holding the stock before Sept. 27th. This is normal and happens each quarter.

However, stock charts take a few days to adjust to the new price so you might see a gap that looks like selling but was actually just a normal reaction to the dividend date and will be removed from most charts over the next month. Our recommended prices are still good and the artificial gap created by the ex-date does not affect our recommendation.

NLY 5-Year

An REIT like NLY performs like a bond purchased at par while SPG is similar to a moderate dividend-yielding growth stock. NLY can still see price appreciation, but this stock stays in a relatively tight channel partly due to its executive compensation plan: Management compensation is tied directly to book value.

Since a REIT must pay out at least 90% of earnings, NLY usually turns to capital raises, issuing equity when the share price rises enough. This puts a drag on any upside momentum, and is another reason the stock has remained steady for years. NLY isn’t the place for quick gains — it’s an income producer that’s in the right place.

Given how long rates may stay near zero, NLY is a refreshing oasis in a land of barren yields.

NLYchart 1024x563 Looking for Yield? Look No Further

Options Trading Alternative

A high-dividend payer like this will exhibit funny option pricing to traders who have never bought calls on a REIT. If everything else remains equal, NLY’s stock price will drop by the amount of the dividend with each payout.

However, call buyers don’t get the dividend (unless they exercise) so long-term calls are cheap. If NLY’s long-term trend remained flat, that would make these calls unattractive, but we expect that Fed buying pressure and yield-seeking investors will drive the price of NLY much higher. We recommend buying to open the January 2014 $17 calls for 60 cents or less. That option carries very little time-value because of the dividend issue, so it should gain in value penny for penny with the stock.

As of this writing, John Jagerson and Wade Hansen did not own a position in any of the aforementioned securities.

Endnotes:
  1. NLY: http://studio-5.financialcontent.com/investplace/quote?Symbol=NLY
  2. SPG: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPG

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