Why Shares of Annaly Capital Management Are Up 21% in 2014

Annaly Capital Management (NYSE: NLY  ) and the mortgage REIT sector in general have had a pretty good 2014 so far. In fact, Annaly has produced total returns of more than 20% for its shareholders so far in 2014. How has the company delivered such great performance after such a dismal 2013? And what can we expect for the rest of the year?

NLY Total Return Price Chart

What caused the gain?
Simply put, Annaly has done so well in 2014 because the interest rate market has calmed down and the company has been able to do what it does best: use leverage to profit from the spread between the interest rates paid by mortgage-backed securities and the rates they can borrow money to invest.

As you can see from the chart below, mortgage rates spiked and were unpredictable for much of 2013, rocketing upward in May and June, then jumping around for the rest of the year.

US 30 Year Mortgage Rate Chart

When rates are uncertain, it gets difficult for companies like Annaly to hedge their portfolios, and spiking rates cause the value of the underlying mortgage-backed securities to plummet. This caused Annaly to lower its leverage rate significantly to brace for further volatility. Lower leverage means less income, and that means less money to pay shareholders in the form of dividends.

As soon as the Federal Reserve's long-anticipated taper was announced, the interest rate volatility subsided and mortgage REITs like Annaly were able to go back to business as usual. And, since Annaly reduced its leverage from about 7-to-1 to 5-to-1 in order to ride out the interest rate storm, the company is in an excellent position to capitalize on future opportunities.

What does the rest of 2014 have in store?
The rest of this year could be pretty smooth sailing. Mortgage REITs thrive in environments of predictability, and the Fed is giving that gift to the markets right now. Annaly's share price is extremely reactive to its dividend yield, so now that it's pretty apparent the dividend cuts are over with, shareholders are much more optimistic.

Janet Yellen has stated the Fed's intention to keep rates very low for the "foreseeable future". As long as the inflation rate doesn't climb too much above the Fed's 2% target (currently at 1.5%-1.7%), there is no need to worry about any rate hikes in the immediate future.

Essentially, the Fed's worst nightmare is pulling the trigger on rate hikes too soon and derailing the economic recovery which has made pretty good progress. Because of this, when rates finally do rise, it's a pretty safe bet that the increases will be in a gradual, controlled manner, and that the Fed will use its monthly meetings to allude to its intention to raise rates several months before it actually happens.

In short, the Fed is giving mortgage REITs the optimal environment in which to grow and thrive...an environment of predictability.

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