Rising Star Buys: Annaly Capital and Chimera

This article is part of our Rising Star Portfolios series. You can read about the Dada Portfolio here.

The enormous dividend yields residential mortgage REITs offer right now has made them a tempting target for yield-hungry investors.

In fact, the real-money Dada Portfolio I co-manage has bought shares of Annaly Capital for its juicy yield. For us, owning mortgage REITs is a short-to-medium-term play and hedge on a difficult economy.

As the Federal Reserve holds its overnight interest rate to close to 0% to combat high unemployment and low inflation, REITs' funding costs have fallen through the floor. Residential mortgage REITs borrow cheap, short-term loan funds, which they use to buy higher-yielding, longer-term mortgage-backed securities. The profit margin between their borrowing costs and interest income -- known as the interest rate spread -- is relatively wide today. Hence those massive dividend yields.

The 10 highest-yielding REITs
I've put together a table comparing the 10 highest-yielding REITs, so you can compare how individual companies generate their respective dividend payouts. Notice how some (Invesco, Two Harbors, and Chimera) produce abnormally high interest rate spreads, while others utilize greater leverage to boost their returns.

Roughly speaking, higher interest rate spreads suggest the use of riskier, non-Federally guaranteed loans that are subject to potential default from borrowers, whereas higher leverage can juice returns from safer loans but can put a portfolio at greater risk to future interest rate increases.

I've also included trailing book value growth to give you a sense of which managers avoid diluting shareholders during those relatively frequent REIT capital raises. (As the current mortgage REIT boom has led to a proliferation of new companies, not all have five-year histories.)

Company

Dividend Yield

Interest Rate Spread, 2010

Debt-Equity Ratio

5-Year Book Value Per Share Growth

Price-to-Book Value

Cypress Sharpridge (NYSE: CYS  )

     19.2%

     2.15

5.5

-

     1.06

American Capital Agency (Nasdaq: AGNC  )

     19.0%

     2.33

6.6

-

     1.14

Invesco Mortgage (NYSE: IVR  )

     17.6%

     3.63

3.7

-

     1.07

Two Harbors Investment (NYSE: TWO  )

     14.9%

     4.70

 3.8

-

     1.08

Chimera Investment (NYSE: CIM  )

     14.5%

     4.90

1.8

-

     1.12

Hatteras Financial (NYSE: HTS  )

     14.0%

     2.26

6.1

-

     1.09

Anworth Mortgage

     14.0%

-

      

7.5

    

(7.0%)

     1.03

Annaly Capital (NYSE: NLY  )

     13.9%

     2.08

6.3

7.0%

     1.13

Capstead Mortgage

     12.6%

     1.74

8.7

7.0%

     1.07

MFA Financial

     11.6%

     2.47

2.9

(1.0%)

     0.99

Source: Capital IQ, a division of Standard & Poor's. Includes companies valued at more than $500 million.

While REITs are enjoying fat spreads on portfolios primarily comprised of Federally guaranteed mortgages, which they lever up considerably, Chimera (which is managed by Annaly Capital) has a more daring operational model: It buys primarily riskier mortgages, which generates a higher spread but forces management to be more conservative with leverage. About 80% of its portfolio is junk or unrated. That said, management appears somewhat bearish on housing and is treading carefully so it can pounce if mortgage-backed security prices decline further.

We'll be increasing our REIT holdings to create a high-yield hedge should the recovery remain sluggish, as we generally expect it to. We'll do so by opening a position in Chimera and buying more shares of Annaly because we like management for its long and successful track record and insightful commentary.

The biggest risk is that the Fed could raise short-term interest rates in response to inflation fears. This would increase borrowing costs -- cutting into profits and causing investors to flee for the exits. In 2005, after one and a half years of gradual rate increases, the Fed Funds rate rose from 2.25% to 4.25%. Annaly's net income fell from a then-record $250 million to a $9 million loss, and shares plunged nearly 50%.

Despite headlines insisting on looming inflation, we believe unemployment remains the greater danger in today's economy and that we still have at least a year or two before the Fed begins to raise rates and probably longer before rates increase in earnest. So we're buying another $500 of Annaly and $300 of Chimera for total position sizes of 6% and 2%, respectively.

If you'd like to stay up to speed on the top commentary and analysis on Annaly and Chimera or any other stock you're interested in, click here to add them to your watchlist. You'll get free, personalized updates on companies you are interested in. You can follow the Dada Portfolio on our discussion board or Twitter @TMFDada.

At the time of publication, Ilan Moscovitz didn't own shares of any company mentioned. The Motley Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (30)

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 May 20, 2011, at 7:11 PM, dragonmonkey wrote:

    I'm curious why you would open a $300 position on a 1-2 year play. I don't know about you, but I pay $9 per trade. For a $300 position, that's 3% on the front end and another 3% on the back end. Ouch...6% in transaction fees for the year. Plus the dividends are taxed at a higher rate (income vs cap gains), so you are really cutting heavily into the reward portion of the risk/reward analysis. I would think you need to invest a little more up front to make it worthwhile.

    BTW, I'm not against the companies per se. I have some Annaly in my portfolio. I will probably sell in the next year if I think interests rates will rise, and I wouldn't have bothered to make the investment unless the dividends could more than make up for my transaction costs.

  • Report this Comment On May 20, 2011, at 8:16 PM, HectorLemans wrote:

    I'd really like to see an article on REITs that specialize in building data centers. Since computing is starting its shift to the cloud, seems like this might be a high growth sector (plus the good dividends that go with REITs).

  • Report this Comment On May 20, 2011, at 10:52 PM, TMFDiogenes wrote:

    @dragonmonkey,

    Great question. We're managing a very diversified Dada portfolio, and we aren't dinged with commissions on it. Otherwise I wouldn't want to pay those kinds of transaction fees.

    Fool On,

    Ilan

  • Report this Comment On May 20, 2011, at 11:27 PM, alanddee wrote:

    I have all the REITs on your list and the only one thats not that good is CIM as far as price (bought most at 3.99 and 410)..I would like to see it go up..Al

  • Report this Comment On May 21, 2011, at 11:48 AM, joshn268 wrote:

    I'm a junior Fool and still trying to about REITs. It seems to me that when interest rates rise, which I also believe will happen within the next year or so, it would present a really nice buying opportunity. After all, the economy will rise and fall as will interest rates so I'm curious why you wouldn't wait until then to buy these companies at a discount so you can get the share price appreciation (when interest rates fall) coupled with those fantastic dividends.

  • Report this Comment On May 21, 2011, at 12:22 PM, maiday2000 wrote:

    I am confused, here. For the past 18 months, every columnist at the Motley Fool has been tearing down Mortgage REITs as terrible investments. Meanwhile, I have made thousands of dollars in dividends with no loss of capital. Does the change in sentiment by Mr. Moscovitz indicate a sell signal???

  • Report this Comment On May 27, 2011, at 3:02 PM, ichbinhxm wrote:

    Is a crap shoot for most investments; only WS masters make money via manipulation;they are in control; one small investor needs to be lucky to make real $$.

  • Report this Comment On May 30, 2011, at 8:53 PM, hbolourchi wrote:

    Are these high yielding REITS better for IRAs or taxable accounts?

    Thanks,

    HB

  • Report this Comment On May 31, 2011, at 10:35 PM, rlschubnel wrote:

    I like these high yield REITs mainly for my IRA - tax free until withdrawal, so the tax bite is delayed. Have held NLY in both IRA and taxable accounts with good results since 2002. Others in IRA only include HTS and IVR, plus RSO - a commercial REIT with a 1.1:1 book value and yield of around 15%.

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Related Tickers

8/21/2014 4:01 PM
CIM $3.26 Up +0.02 +0.62%
Chimera Investment CAPS Rating: ***
NLY $11.92 Up +0.06 +0.51%
Annaly Capital Man… CAPS Rating: ****
AGNC $23.46 Up +0.10 +0.43%
American Capital A… CAPS Rating: ****
CYS $9.31 Up +0.02 +0.22%
CYS Investments CAPS Rating: ****
HTS $19.80 Up +0.04 +0.20%
Hatteras Financial CAPS Rating: ****
IVR $17.39 Up +0.07 +0.40%
Invesco Mortgage C… CAPS Rating: *****
TWO $10.54 Up +0.04 +0.38%
Two Harbors Invest… CAPS Rating: ****

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