Investors fled the mortgage REIT space ahead of higher short-term borrowing costs and the end of the Federal Reserve's purchases of mortgage-backed securities. But a look at how one high-yield mortgage REIT performed over the past two cycles of higher rates may indicate the worst is over.
Annaly Capital Management (NYSE: NLY) is the largest publicly traded mortgage REIT. It invests mostly in government-sponsored and agency mortgage-backed securities.
Agency debt doesn't pay as high a yield but carries an implicit guarantee by the government, so it involves almost no credit risk. That means the company is able to borrow on extremely low short-term rates and lend on higher long-term rates.
The downside is that the interest spread is extremely low -- just 0.76% in the third quarter. To increase profits, companies use debt many times the equity on their balance sheets.
Annaly has significantly reduced its debt leverage over the past decade though. Its debt-to-equity ratio was as high as 9.8 in 2005 but fell to just 5.9 last year. This is well below the industry average of 8 times equity. Even if management decides to maintain a conservative balance sheet, it could still increase leverage to support earnings growth.
Per regulatory requirements, Annaly can invest up to 25% in commercial real estate and non-agency residential debt. These mortgages offer higher yields over agency-backed mortgages and Annaly has been increasing its exposure to them over the past few quarters. They represented 18% of the company's total equity allocation in the third quarter, up from just 13% in the previous quarter.
Why The Worst May Be Over
After peaking around $16 in March 2013, NLY began to fall as investors prepared for the end of the Fed's quantitative easing program, which came in October 2014.
More recently, fears of higher rates have weighed on the stock, with shares off nearly 18% from their 52-week high, made in March 2015. But those fears may be overblown. As we can see in the chart below, NLY has held up during the past two cycles of rising rates.
While both periods of rising Fed funds rates -- between mid-1999 and mid-2000 and between mid-2004 and mid-2006 -- coincided with declines in Annaly's share price, both followed periods when the shares rose dramatically. By comparison, the steep drop in the shares recently may mean that investor sentiment has taken the stock down as far as it's going to go.
Double Annaly's Already Lofty Yield
At current prices, shares look undervalued. While earnings admittedly disappointed in the third quarter, book value held up well at $11.99 per share. NLY now trades for just 0.72 times book value, a discount of 28% on the five-year average multiple of 1.
Annaly is taking advantage of the discount by authorizing the repurchase of up to $1 billion in shares through December 2016, almost 12% of its market capitalization.
It is also returning cash to shareholders in the form of dividends. The company pays an annual dividend of $1.20 per share for a current yield of 13.3%.
That's an impressive yield, but using a covered call strategy -- which involves purchasing 100 shares of NLY and then immediately selling a call option on the position -- we can more than double it. (If you're not familiar with how a covered call works or need a refresher, watch this 90-second training video now.)
With NLY trading around $9 at the time of this writing, we can buy 100 shares and simultaneously sell one NLY April 9 Call, which is trading around $0.35 ($35 per contract), for a net cost of $8.65 per share.
If NLY closes above the $9 strike price at expiration on April 15, our shares will be sold for that price. In this case, we will make a gain of $0.35, plus the March dividend payment of $0.30, for a total return of $0.65 per share. This represents a profit of 7.5% over our cost basis of $8.65. Since we'd earn that in 82 days, it works out to an annualized gain of 33% -- which is more than double the stock's already lofty yield.
If NLY closes below the $9 strike price, we keep the premium and the shares and can sell more calls to generate additional income.
In light of recent global economic weakness and the plunge in asset values, the Fed has all the excuse it needs to keep rates from increasing. With rate fears already overblown, shares of Annaly have an open road higher.
Note: A covered call strategy like this one can be applied to almost any stock currently sitting in your portfolio as long as you hold at least 100 shares. To find out how you could pocket $795 in the next 48 hours -- and earn up to $3,000 a month -- from covered calls, follow this link.
This article was originally published on ProfitableTrading.com: Double This Oversold Stock's Mega-Yield