Can Annaly Capital Management, Inc. (NLY) Out Maneuver The Fed?

Annaly Capital (NLY)In its bid to out-maneuver the Fed’s policy of keeping the rates low, Annaly Capital Management, Inc. (NYSE:NLY) disclosed its interest in purchasing the remaining stocks of Crexus Investment Corp (NYSE:CXS). CreXus Investments specializes in the acquisition and management of commercial mortgage backed securities. Annaly Capital currently holds around 12.4% of CreXus and the full acquisition would provide risk-adjusted returns to shareholders, while at the same time act to diversify Annaly’s asset portfolio.

Besides the acquisition, Annaly Capital has been busy improving its capital strategy over the past 12 months in its attempt to continue to deliver income for its investors. It has met success in lowering its cost of capital through the issuance of $1.5 billion of convertible notes and preferred equity. It has also extended the duration of its borrowings by 93 days. Besides these efforts, the company has restructured its capital by buying back its convertible notes worth $447.1 million and also announced a share buyback program of up to $1.5 billion.

The company is famous for its double digit dividend yield and for generating income by investing in mortgage backed securities. It earns a spread between its own cost of capital and interest payments received on the invested MBS. Another source of income for Annaly is the dividends it receives from its subsidiaries. The company’s operations are highly linked to the policies of the Fed. Therefore, it has experienced a significant downfall in both its net interest spread and the net interest income. As the Fed lowered the interest spreads through Operation Twist and QE3, Annaly reported an EPS of $0.45 per common share for the third quarter of 2012, missing the estimate by $0.02.

The Fed is meeting this week to consider whether to end its unprecedented easing or not. I believe the easing will be here for a large part of 2013. Having said that, I believe diversification is the only way out for pure play mortgage REITs. Armour’s charter already allows it to include assets other than Agency MBS. Therefore, if American Capital Agency Corp. (NASDAQ:AGNC) and ARMOUR Residential REIT, Inc. (NYSE:ARR) also consider such diversifications, they would experience in their interest incomes.

Dividends

The stock offers a dividend yield of 12.12%, compared to 1.88% offered by the 10-year Treasuries. This is compared to 15.91% and 13.64% offered by the American Capital Agency and Armour Residential REIT, respectively.

Valuations

Annaly has cheap valuations compared to its peers in the Agency mortgage REITs sector. Annaly is trading at 8% discount to its third quarter book value. In contrast, ARR is trading at 6% premium, while AGNC is trading at 13% premium to its book value.

Conclusion

The acquisition and improvements in the capital structure are part of the Annaly’s policy to out maneuver the Fed. The inclusion of CreXus will give Annaly additional access to the high yielding commercial mortgage backed securities. CreXus, the commercial mortgage REITs earns four times more than what Annaly earns. An acquisition would boost Annaly’s income and give it exposure to the commercial real estate market. Therefore, I recommend investors buy Annaly Capital and benefit from its double digit dividend yield.

The article Can This mREIT Out Maneuver The Fed? originally appeared on Fool.com and is written by Waqar Saif.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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