Salve Your Wounds With a 15% Yield

08/03/2011 10:30 am EST


Igor Greenwald

Chief Investment Strategist, MLP Profits

In times like these, the reliability of Annaly Capital’s double-digit returns should be more prized than ever, writes senior editor Igor Greenwald.

It was a nice thesis while it lasted: Consumers in fast-growing emerging markets would provide sufficient demand to boost developed-country exports, lifting the profits of multinationals.

The multinationals, in turn, would rehire laid off workers in their home countries, spurring growth in the stagnant advanced economies.

It doesn’t seem to be playing out this way, right now. The transmission mechanism broke down when most corporates decided they would do the bulk of their hiring closer to the source of faster growth in the emerging world. This labor-cost arbitrage certainly inflated profit margins for a while.

But now, as a result, the US and Europe are saddled with too much debt and unemployment, and not enough growth. Their economies are stumbling under these burdens. Instead of using Asia and Latin America as a crutch, they are now exporting fears of a financial collapse.

The stock market, fresh from celebrating another quarter of strong earnings, is just starting to wake up to this set of dismal facts. Corporations that were supposed to lead the rest of the economy to renewed prosperity now face the prospect of getting pulled back into the muck by all the little people they didn’t hire and many others who are no longer keen on spending.

The rest of August and September will now be devoted to wondering how badly the economic slowdown (which could metastasize into a full-blown recession) will hit corporate profits. This is not a healthy backdrop for equities.

The Dow is down eight straight days for the first time since October of 2008, and if it ends in the red today it will have suffered its longest losing streak in 33 years. One of these days stocks are bound to rise.

But this market is now guilty until proven otherwise, which won’t happen until the economy improves—or, at the minimum, until some dip-buyers emerge from witness protection.

Yesterday, I wrote about lightening up in the retirement portfolios I manage for relatives. All that remains there are gold-mining proxies (GDX and GDXJ), grains (JJG) and a smattering of the strongest techs (AAPL) as well as others too cheap to dump at current prices (ORCL).

That’s worked out well over the last couple of days, but is unlikely to prove satisfactory for long. With the world looking high and low for alternatives to the US dollar, and with the US economy struggling because its workers are not competitive with foreign counterparts at the current exchange rate, the path of least resistance for the greenback is down. Holding dollar-denominated cash seems a lot like holding the bag.

So the hunt for yield is on, or so we’ve been told for quite some time, except that some of the yields on offer suggest the hunt has barely begun.

NEXT: As Promised, the Big-Yield Play


One that looks especially attractive at the moment is Annaly Capital Management (NLY). Annaly currently yields 15% by leveraging its holdings of US mortgage-backed securities, all of which carry explicit or implicit government guarantees.

With a leverage of, say 6 to 1 on the spreads between agency debt and US Treasuries, Annaly’s portfolio is as close at one can come to a private money press. Earnings reported Monday surpassed estimates, and the spread between what Annaly earns on its assets and what it pays to borrow widened to 2.45%, from 2.17% three months ago.

The stock had had a tough July, capped by a sudden plunge Friday on fears that if the US government defaulted Annaly’s credit might dry up, or credit costs might rise. That didn’t materialize, of course, and the stock had already rebounded anyway.

If anything, the economic deterioration of recent weeks simply ensures that Annaly’s biggest risk—a sudden spike in US interest rates—has been deferred for that much longer.

Nor is it particularly vulnerable to prepayment risk if rates head significantly lower—many of the borrowers ultimately contributing to its cash flows either can’t refinance any more, or have already done so.

As CEO Michael Farrell noted Monday, “The uncertainty surrounding sovereign credit risk, regulatory reform and tepid economic performance is causing near-term volatility in asset prices and investor confidence, but the long-term implication of these conditions is that the very favorable operating environment in which we find ourselves is likely to persist for a significant period of time.”

The company raised $2.4 billion via a secondary offering last month, which at its recent leverage ratio of 5.7 to 1 should translate into $13.7 billion of interest-bearing assets.

Annaly’s sterling long-term record matters a great deal here. To get a sense how it’s performed over its 14 years as a REIT, take a look at this chart from the corporate Web site:

Click to Enlarge

I first wrote about Annaly in the summer of 2008, as people were lining up to get their money out of Countrywide, and it’s proven one of my better calls, holding up and delivering double-digit returns right through the Lehman bankruptcy, the subsequent market crash, and then a bull market.

Right now it’s an open question whether that bull is mortally wounded or not. But higher rates are clearly not in the cards, and the stock market will need to learn to walk again before it can run.

In these circumstances, a 15% yield from a proven long-term winner, expertly run, is a gift. I expect Annaly’s share price to rise in the near future as equities refugees pile in.

  By clicking submit, you agree to our privacy policy & terms of service.

Related Articles on MARKETS