Is Annaly a Value or a Value Trap?
What Annaly Capital Management needs is another financial crisis. As the economic picture has improved over the past two years, the company has been forced to cut its dividend by more than a third, sending its shares plummeting by 37% over the same time period.
This is obviously bad news if you're a shareholder of Annaly. But what's less clear is whether or not the company is now worthy of a value investor's attention.
Is Annaly a value or a value trap?
Like any other type of leveraged investment vehicle, a mortgage REIT like Annaly borrows money at relatively low short-term interest rates and then uses the proceeds to invest in longer-term assets that yield substantially more. In Annaly's case, these assets consist predominantly of mortgage-backed securities that are guaranteed by either Fannie Mae or Freddie Mac.
The upside of this strategy is that it insulates Annaly from credit risk -- that is, the risk that it'll be left holding the bag if the underlying mortgagees default. But the downside is that its exposure to interest rate risk is magnified. Indeed, as you can see in the chart below, it's no exaggeration to say that Annaly's coveted dividend lives and dies by the spread between long- and short-term rates.
One couldn't have dreamed up a better investment scenario than the financial crisis for a company that makes its money this way. Short-term interest rates dropped to near zero as the Federal Reserve sought to jump-start the economy, but it took long-term rates more time to follow suit. And it was in the intervening period that Annaly and its competitors were free to mint money.
The catch was that everyone knew the party would end, they just didn't know when. This is because interest rates move in cycles. In boom times, the spread between short- and long-term rates is typically tight. When times are tough, it's wide. As a result, any hint of an economic recovery is anathema to Annaly. And that's precisely what we're in the midst of.
Now, to be clear, the present trend in long-term interest rates -- and particularly mortgage rates -- is up. But there are two things to note. In the first case, the dramatic uptick in rates that occurred last month had a detrimental impact on the value of Annaly's current portfolio, as interest rates and the value of mortgage-backed securities are inversely related. The net effect was to drop Annaly's book value by $2.16 per share in the most recent quarter.
And in the second case, it's only a matter of time before the central bank relents and raises short-term rates as well. Will this happen soon? Not likely, as the Fed noted following its most recent meeting, "the Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens." But it will happen, and markets are forward-looking institutions.
The point is that, Annaly's massive dividend yield may make it appear to be a value when, in reality, it's a value trap.
Dividend stocks can make you rich. It's as simple as that. While they don't garner the notoriety of high-flying growth stocks, they're also less likely to crash and burn. And over the long term, the compounding effect of the quarterly payouts, as well as their growth, adds up faster than most investors imagine. With this in mind, our analysts sat down to identify the absolute best of the best when it comes to rock-solid dividend stocks, drawing up a list in this free report of nine that fit the bill. To discover the identities of these companies before the rest of the market catches on, you can download this valuable free report by simply clicking here now.
The article Is Annaly a Value or a Value Trap? originally appeared on Fool.com.John Maxfield has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.