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Buy, Sell, or Hold: Annaly Capital

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There are certain numbers that make you jump up and take notice. They're so cartoonish that half of your brain screams, "Opportunity!" while the other half cries, "Red flag!"

A 15% dividend is such a number.

The semi-obscure Annaly Capital (NYSE: NLY  ) sports that dividend. The company is structured as a REIT, but it is basically a trading desk purchasing mortgage-backed securities. They make money on the spread between the interest they earn on the securities and the interest they pay to borrow funds. Through a subsidiary, they also act as the external manager of the publicly traded REITs, Crexus (NYSE: CXS  ) and Chimera (NYSE: CIM  ) . If you're interested in Annaly, these other two are also worth a look -- Chimera's dividend is even larger than Annaly's, at 17.8%.

But for now, join me as I break down the arguments to buy, sell, or hold Annaly.

Buy: Recently, the interest rate environment has allowed fixed income traders (Annaly Capital among them) to record huge gains. Why? With the Fed keeping borrowing costs low, these companies are achieving historically great interest rate spreads between what they've bought and what they're borrowing.

These spreads have also bloated the bottom lines of Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , JPMorgan (NYSE: JPM  ) , and Goldman Sachs (NYSE: GS  ) . So why would an investor want Annaly versus the big banks? Annaly is laser-focused on mortgage-backed securities that are guaranteed by the government-backed entities like Fannie Mae and Freddie Mac. They aren't going crazy with too many exotic instruments like Citi, B of A, JPMorgan, and Goldman did. 

Sell: But this party ends. For each of the banks and for Annaly, these spreads will contract and earnings will be compromised. Annaly is locking in these spreads by purchasing interest rate swaps equivalent to a good chunk of their portfolio, but 1) that only holds if they've done their hedging right and 2) it's not a full hedge.

In addition, Annaly's major funding source is the repurchase market -- i.e., the same stuff that sank Bear Stearns and Lehman Brothers. Annaly does on average use longer-term agreements – unlike the overnight repurchase agreements the Wall Streeters revel in. However, this is all a pretty complicated money-making system. Some investors will (and should) put Annaly in the "too hard" bucket.  

Hold: Annaly is currently selling at low multiples, but the interest rate spread risk is real. There are real risks and real rewards here.

The bottom line
For investors who have the skill and time to understand the nuances of Annaly's machinery and perform their own due diligence, I lean toward a buy at today's prices. Check out the three most compelling numbers at Annaly here.

For some more dividend-loving stocks, check these two out.

Anand Chokkavelu owns shares of Citigroup. The Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (21)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 16, 2010, at 5:35 PM, mbgumm wrote:

    I've looked everywhere, and I haven't found anyone mention this yet. Since the majority of holdings are CMOs, I've been wondering if there is a percentage of that dividend payout which is return of principal. Is there some way to verify that?

  • Report this Comment On July 18, 2010, at 4:31 PM, zeppelin1704 wrote:

    We have owned NLY for several years and have never had any of the dividends classified as return of capital. They are treated as ordinary dividends, not qualified dividends, but that distinction will disappear when the current tax laws expire at the end of this year.

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