Author: Bill DeShurko, 401 Advisor
Covestor model: Dividend and Income Plus
Disclosure: Long NLY
On the heels of an announced dividend reduction by Annaly (NLY), the articles are streaming in on reasons to now avoid or buy NLY for your portfolio. Since I am long NLY in client portfolios, and I have recently used NLY as an example of how to hedge a high dividend portfolio, I thought I should weigh in on the debate.
Annaly is a mortgage REIT. They make money by borrowing at low interest rates and reinvesting in higher interest rate mortgages. The company therefore benefits from a steep yield curve, as we have now . The current concern is that as the Fed works to keep mortgage rates low, this spread is narrowing, which cuts into NLY’s profitability and causes a dividend cut. Following the adage “Don’t fight the Fed” some observers are recommending it is time, if not already past time, to be a seller of mortgage REITs.
Here are my reasons to continue holding NLY, with one caveat:
1. Price Action. Let’s get back to basics. The price movement of a stock represents the net opinion for that stock. NLY has moved up since the announcement of their dividend cut. When is the last time you saw that? Obviously, the net opinion is that the dividend cut is an overall good thing.
2. Leverage. NLY has one of the lower leverage ratios in the mortgage REIT space. In an environment of low and falling mortgage rates, lowering your leverage and lowering your dividend makes a lot of sense for the long term investor.
3. Fed Action. NLY is decidedly not fighting the Fed with their duel reductions in leverage and dividends. What they may be doing is waiting to take advantage of the Fed. As the Fed purchases mortgages from their member banks, they are added to the Fed’s balance sheet. It is unlikely that the Fed wants to keep them there.
With major financial problems still brewing in Europe that could spill over to U.S. banks, the Fed too needs to keep its powder dry by having plenty of cash available. (Sure, they can just have it printed, but politically it makes more sense to use their current assets than to create more money.) The Fed therefore are likely sellers of the mortgage pools that they are buying. Since it would be counter-productive to sell them back to other member banks, a logical buyer would be mortgage REITs, like NLY. In other words, there could be bargains to be had as the Fed seeks to move these off of their balance sheet.
4. Agency Mortgages. The government hasn’t let Fannie and Freddie go bust yet, and at this point I think it is unlikely that they will. Since NLY focuses on agency mortgages, there is some presumed level of security in their underlying assets.
Caveat: I would add an investment hedge to a holding of NLY. Look at a stock that has not only paid, but consistently increased its dividend. A couple of candidates might be Procter & Gamble (PG), McDonalds (MCD) or Verizon (VZ). A simple equal dollar weighted portfolio of all four stocks would provide a 6.14% dividend yield, based on yields and prices on 12/22/2011 (Source: MarketWatch).
