Why Annaly and American Capital Agency Soar When the Economy Suffers

An interesting thing happened on Friday after the Labor Department reported worse than expected jobs figures for March: while the major stock indexes fell, shares of Annaly Capital Management and American Capital Agency both headed higher.

To the discerning investor, this is far from a bad thing. It's quite the opposite, in fact, given that a well-diversified portfolio includes stocks that move in opposite directions. But this doesn't answer the question of why Annaly and American Capital themselves are out of sync.

The answer is quite simple. Both of these companies are mortgage REITs that earn money by borrowing funds at cheap short-term rates and then using the proceeds to purchase higher-yielding mortgage-backed securities.

The net result is that Annaly and American Capital live and die by the level of interest rates; more specifically, by the relationship, or "spread," between short- and long-term rates. The higher the spread, the bigger the profit.

Somewhat complicating matters is the fact that the value of the securities held by these companies is inversely correlated to long-term interest rates. When rates rise, the value of Annaly and American Capital's massive MBS portfolios drop.

Suffice it to say, this leads to a delicate balance. On the one hand, higher long-term rates typically make mREITs more profitable. But on the other, elevated rates exert a negative influence on their portfolio values.

As an example, the following table contains Annaly's projections for what would happen in the event that short- and long-term interest rates rose or fell in a parallel fashion by various degrees over the next 12 months.

Change in Interest Rate

Projected Change in Annaly's Net Interest Income

Projected Change in the Value of Annaly's Portfolio

-75 basis points



-50 basis points



-25 basis points



Base interest rate



+25 basis points



+50 basis points



+75 basis points



Source: Annaly Capital Management.

At first glance, it may appear that the threat/boost to Annaly's net interest income is significantly more serious/promising than that to book value. After all, if interest rates rise by 75 basis points, its net interest income would increase by 13%, versus only a 1.7% drop in the value of its portfolio.

It's important to note, however, that this isn't an apples to apples comparison. While a 13.7% increase in net interest income equates to an additional $314 million in revenue, a 1.7% drop in the value of Annaly's $70-billion MBS portfolio equates to a $1.2 billion loss (albeit, only on paper).

And herein lies the reason that a disappointing jobs report fuels rather than hinders shares of Annaly and American Capital. The Federal Reserve is less likely to increase interest rates when the jobs market is faltering. Consequently, as far as stocks are concerned, the best thing for shareholders in most mREITs is the worst thing for the U.S. economy.

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The article Why Annaly and American Capital Agency Soar When the Economy Suffers originally appeared on Fool.com.

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