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Published: August 30, 2010
Retirees and others that rely on income
from their investments will be the first to tell you that
interest rates are not what they used to be. Prior to the credit
crisis, an individual with $2 million saved up could achieve a
six-figure income just by holding a diversified basked of fixed
income securities.
These days, locking your money up for 30 years with Uncle Sam
will net you a
yield of less than 4%. Ten-year Treasuries yield
a stingy 2.6% these days, while money market funds essentially
yield nothing. Add in the effects of
inflation, and real rates
are also next to nil.
The sad state of the
yield curve has caused many investors to
stretch for income, including forays into junk bonds and stocks
with above-average dividend yields.
One of these stocks with above-average yields is Annaly
Capital Management (NYSE: NLY). Annaly is a
real estate
investment trust (REIT) that invests primarily in mortgage
pass-through certificates, collateralized mortgage obligations,
agency callable debentures and other mortgage-backed securities
representing interests in or obligations backed by pools of
mortgage loans.
As scary as that may sound at first glance, the business is
relatively simple. Annaly borrows money and uses it to buy a
portfolio of mortgage securities. Like a traditional bank, it
earns a spread between its borrowing costs and returns it
receives on its investments. The investments consist of
securities that were created from packaging mortgages from
single-family and multi-family residential homes, and to a
lesser degree
commercial real estate. At least 75% of its assets
must be backed by the government, which these days consists of Ginnie Mae,
Freddie Mac and Fannie Mae.
The company has profited handsomely from a steep yield curve ,
which is simply a chart of interest rates over a range of
maturity dates, as it has been able to borrow at extremely low
short-term rates, invest those funds in the above categories,
and earn a high yield on those investments. High may be an
understatement -- the current
dividend yield is 15.7%.
It's easy to see why Annaly has caught the
attention of yield-hungry investors. The bullishness is pretty
widespread, as it's difficult to find a negative or even
cautious opinion on the stock. However, there are a number of
potential pitfalls that warrant mention.
A review of Annaly's risk factors in its SEC filings covers
these pitfalls rather comprehensively. This section speaks to
several factors. First, the mortgage-related assets the company
invests in can be highly illiquid. Changes in laws and
regulations in regard to Ginnie, Freddie and Fannie could hurt
Annaly's business. A change in interest rates could also impact
the spread Annaly earns on its investments and could seriously
dent its profitability. This could happen if short-term rates
rise or long-term rates fall, which makes buying investments
less appealing. Finally and most significantly, Annaly has
significant
leverage that it uses to juice profits.
The above risks are admittedly general in nature, and Annaly has
been easily navigating them while returning impressive sums to
shareholders. However, they do leave the company open to
significant downside risk. A primary near-term risk is a jump in
prepayments, which happens when individuals or commercial real
estate owners refinance their mortgages to take advantage of
lower rates. Annaly detailed that prepayments increased during
its most recent quarter, though a fall in interest rates also
reduced its funding costs. Mortgage rates have hit fresh
all-time lows, so prepayments are likely to increase.
The most serious risk facing Annaly is another market
dislocation that either bumps short-term rates, lowers long-term
rates, or alters the upward slope of the yield curve in any way.
The credit crisis served as a prime example of what this can do
to companies, as firms including Lehman Brothers and AIG
(NYSE: AIG) were hit with an inability to fund their
businesses and disputes over the value of assets that became
illiquid in sudden fashion.
Another example stems from a similar REIT called CRIIMI MAE ,
which went bankrupt in 1998. The Asian financial crisis caused
the value of its mortgage backed securities to plummet in value
just as its ability to obtain liquidity to fund its business
collapsed. Annaly's business is't identical to CRIIMI's, but it
does demonstrate that an unforeseen financial crisis can hammer
a highly indebted firm that invests in mortgage assets.
Action to Take --> Annaly
has a number of significant pitfalls to navigate in running its
operations. A market disconnect is the biggest concern, along
with other risks exist, such as an unforeseen jump in short-term
rates, higher than expected mortgage prepayment rates or
regulatory changes in the mortgage market that adversely affect
its profitability.
Given these risks, it is best to be on the safe side and
conclude that its high
dividend is likely too good to be true
over the longer term.
-- Ryan Fuhrmann
Contributor
StreetAuthority |
