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Editor's note: A previous version of this article was unclear about the fiscal cliff's tax implications for Annaly's dividend. The Fool regrets the oversight.
As the stock market continues to react every time anyone of consequence in Washington reflects on the "fiscal cliff," it is critical that you make realistic assessments of what various eventualities mean for both your portfolio and the companies it contains. The mREIT industry, specifically its standard bearer, Annaly Capital Management (NYSE: NLY ) , is likely to feel the impact on the business level and from the perspective of investors as the company pays out more than 90% of its earnings as a dividend in order to avoid adverse tax consequences. Ultimately, it's taking the necessary steps to remain competitive, making the stock a buy for your core portfolio as long as it fits properly within your tax plan.
The fiscal cliff and dividends
The fiscal cliff refers to the series of automatic tax hikes and spending cuts that are set to go into effect beginning in January unless Congress intervenes. As Stephen Colbert explains, "It's like Congress put a gun to the economy's head and swore it will pull the trigger if Congress doesn't put its own gun down." Humor aside, it is widely accepted that the scheduled shifts in fiscal policy are sufficient to send the economy into another recession. It is against this backdrop that the market is reacting to every nuanced piece of news.
An element of the fiscal cliff is the shift in the treatment of dividend income. Under the current tax law, dividends are taxed at a flat 15% rate, giving this type of income a tax-advantaged status over wage income. As things stand, dividends will be treated as ordinary income for the 2013 tax year, meaning that, at the highest tax bracket, the tax on dividends will rise from 15% to 39.6%. The plan also calls for an income tax hike that will raise this top rate from 35%. The hike will be smaller for those not in the top tax bracket, but in all cases it is significant.
This may sound like a big risk for a dividend payer like Annaly, but as a REIT, the lion's share of its payout is already taxed as ordinary income at the unitholder level. So, if anything, the change in dividend tax rates would improve Annaly's attractiveness when compared with dividends taxed at the current low rates.
One of the primary draws of an mREIT is the large dividend. Annaly offers a dividend yield of 13.6%, while competitors American Capital Agency (NASDAQ: AGNC ) pays out 16% and Chimera (NYSE: CIM ) 13.8%. The basic business model employed by these companies involves borrowing large amounts of capital in the short-term money market -- typically the repo or corporate paper markets -- and then using that capital to purchase higher-yielding longer-term instruments. In the case of Annaly, its focus has been on buying longer-term agency mortgage-backed securities (MBS).
The Federal Reserve's current policy of perpetual quantitative easing has put agency mREITs under particular pressure because the $40 billion per month being pumped into the economy has come through the purchase of agency MBS. While increased buying by the Fed has driven up prices of these instruments, yields fall when prices rise. The company has been able to maintain its dividend in part by realizing capital gains on the appreciating bonds it owns, but replacing them has become increasingly difficult.
The low-interest-rate environment has two additional impacts on Annaly and other mREITs. When rates are low, borrowers are incentivized to refinance their loans. When this occurs, the prepayment of their existing loans causes the bonds that Annaly holds in its portfolio to shrink. As the company's investments shrink, it must replace them, at which point the second impact is felt. With rates being held artificially low, the new bonds tend to carry a lower rate, which cause the spread between what Annaly must pay on its borrowed funds and what it earns to shrink.
Leveraging the future?
While Annaly has managed to preserve its dividend on a pure yield basis, this has been driven by both asset sales and a falling stock price. The company has been able to maintain cash flows by selling a portion of its appreciating, higher-yielding bonds. This is not a sustainable approach for the dividend because these bonds are being replaced at lower spreads, meaning the appreciation will not be perpetual. The falling stock price has meant that a lower payment maintains the rate.
To address some of these concerns, the company recently announced that it will shift as much as 25% of its portfolio away from residential and into the higher-risk, higher-yielding commercial sector. This isn't a completely out-of-the-blue shift, as it's in line with Annaly's stated mandate. However, that Annaly is taking advantage of this "25% option" has the potential to be important. In conjunction with this shift, and as a part of the same announcement, Annaly disclosed its intention to acquire Crexus (UNKNOWN: CXS.DL.DL ) to effectuate the shift. Annaly already holds a 12% stake in the company and would acquire the outstanding shares in the deal.
Annaly is taking the needed steps to adapt to structural shifts in the tenor of the market, which should be seen as bullish for the stock. Too often management teams refuse to see what is taking place until there is no longer time to react. The fact that Annaly is ahead of this is a positive and why the stock belongs in your core portfolio.