This commentary originally appeared on Feb. 21 at 9 a.m. EST on Real Money Pro -- the ultimate traders' resource for actionable trade ideas and in-depth market analysis. Click here to learn more.
Annaly Capital (NLY) is a real "hot-button" stock whenever someone criticizes owning it. Why? In Fed chief Ben Bernanke's zero interest rate policy (ZIRP) world, many people are desperate to find high-yielding vehicles that can provide income to live on, and Annaly certainly seems to fit the bill here.
Briefly, Annaly makes its profits by owning and managing mortgage pass-through certificates, collateralized mortgage obligations (CMOs) and other mortgage-related assets.
I'm going to keep my discussion really simple today in order to allow for some common sense here. Annaly shares closed last week at $16.66 after the company said its next quarterly payout will be $0.57 per share. If that rate were to hold for the next four quarters, it would mean a 13.69% annualized dividend, based on the current quote.
Anyone who reads the financial news has to be aware that mortgage rates are now near post-World War II lows. The first chart below is a look at where typical mortgage rates stood as of Feb. 15, per Zillow.com. The second chart shows that, at the end of last year's third quarter, Annaly's average earning asset yield was 3.85%, its cost of funds was 1.62% and its net profit margin was 2.23%, according to Value Line's Jan. 13 issue.
Annaly was capturing only 2.23% spreads. How then, could the firm be paying 13.69% in annual distributions? The answer is: extreme leverage. Annaly were using 85% debt, or 5.666x leverage, as of the end of September.
In a falling-interest-rate environment, leverage inflates your returns on fixed-income investments. Since rates have been pushed down toward zero, leverage has been a profit enhancer.
Any of our readers who have employed margin-buying in their stock portfolios have felt the adrenaline rush that comes when borrowed money translates into huge gains during bull market surges. You've also probably experienced the panic of sharp losses when the leverage has worked against you, possibly even triggering margin calls from your brokerage firm.
When that has happened, you've needed either to inject more capital or to sell down stocks at exactly the moment you least wanted to do so. Being forced to sell at depressed prices is almost always a bad thing for your portfolio. Failure to deleverage during margin calls can wipe you out permanently.
This is what recently happened with MF Global. The company went bankrupt when it illegally used customer funds to meet its own margin calls, rather than liquidate its own holdings. MF gambled that things would turn around before they got worse, but the firm ended up out of business when all the assets were liquidated -- and MF was still left owing between $1.2 billion and $1.6 billion.
Leverage is risky. Extreme leverage can be fatal.
Annaly is a real estate investment trust. Each year, it's forced to pay out almost all its current-year earnings to shareholders, leaving little room to keep any earnings retained within the company. Annaly has almost no buffer if its leveraged position starts going against it (that is, whenever interest rates start rising again).
At that point, just to survive Annaly will be forced to deleverage, slash its dividend rate and sell as many shares as possible in secondary offerings in order to raise new capital. I cannot tell you if this will happen soon, but it's inevitable that rates will rise again sometime in the future.
Annaly shareholders will end up taking huge losses at that time, likely wiping out years of the double-digit distributions that drew people to buy these shares in the past.
I'm sure that many Annaly lovers will tell me that they'll see the problems coming and exit well before the shares collapse. I heard this same speech from millions of individuals and fund managers back in late 1999 to early 2000 regarding Internet, telecom and technology stocks. We all know how that played out. Most people failed to get out before absorbing major damage.
Common sense tells you that m-REITs showing current yields of 12% to 18% are flashing obvious warning signs. Why else would the vast majority of investors be passing up such outsized yields? Annaly holders want to believe simply because it's tough to accept the sub-1% interest rates available everywhere else.
Annaly's price is lower today than it was one year ago, despite the high yield and the tailwinds of lower interest rates. The only way to avoid a really bad final result is to get out before disaster strikes. Sell Annaly now.
(Let the hate mail begin.)