The Federal Reserve Might Be Annaly and American Capital Agency's Best Friend

If the comments and predictions by one Fed official are accurate, mortgage REITs could deliver excellent returns with low volatility for the next several years.

Apr 1, 2014 at 9:58AM

Despite a pretty rough 2013, there may be a new reason to rally behind mortgage REITs such as Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC). Up until the Federal Reserve announced its taper, interest rates were very volatile, eroding profits and causing extreme uncertainty. However, comments by a top Fed official this week indicate the next few years may be some of the best ever for the mortgage REITs, and now may be the best time to get in.

Interest Rates

Source: 401(k) 2012

Stable rates for years to come?
According to Charles Evans, President of the Chicago Federal Reserve, rates are going to stay at rock bottom levels until at least mid-2015. He said the federal funds rate may start to increase then, but he believes it should be kept at the current level until early 2016 to prevent the risk of halting the economic recovery or of depressing our already low inflation rates.

Once rates do begin to rise, Evans thinks any increases will be very moderate. This, combined with the likely end Fed's bond-buying stimulus by the end of the year should produce a much-needed period of stable, predictable interest rates for the next few years.

What it could mean for your portfolio
In a nutshell, stable rates will mean increased profits, but the actual strategies will vary between companies. Annaly, for example, has systematically lowered its leverage ratio to around five-to-one -- very low on a historical basis for the company,  and even lower compared to other names in the sector. According to Annaly's CEO, the company plans to add considerably to its positions over the next few quarters to take advantage of growing spreads and stable rates. The company has tons of capital to work with, and to bring the ratio back to a more "normal" level of seven-to-one, the company could buy $24 billion in new assets.

American Capital Agency is another story. With the uncertainty in the market, shares were trading for as much as a 25% discount to book value. Instead of saving its capital like Annaly did, American Capital Agency decided to aggressively repurchase its own shares, believing that it was the best possible use of their capital. I couldn't agree more, as this is the equivalent of getting $100 if for every $75 you gave the teller at your bank. Seems like a no-brainer, right? Not only is American Capital Agency positioned to continue to deliver excellent income to its shareholders, but as investor confidence improves, the share price should rise significantly.

Why mortgage REITs love stability
Mortgage REITs like Annaly make their money by borrowing cheaply and then buying mortgage-backed securities, paying a higher interest rate. The difference between the two rates, known as the "spread", is usually small, maybe 2% on the high end. Since investors expect better returns, the companies use high leverage ratios in order to multiply their potential profits. For example, a six-to-one leverage ratio would, in theory, produce a 12% annual yield if the spread is 2%. Unfortunately, this also amplifies their risk level.

Interest Rates

Source: www.lendingmemo.com

Unstable interest rates make for unstable spreads, and if interest rates spike too quickly it means borrowing costs rise and the spread the company receives from its assets can shrink. In order to mitigate the risk, the companies de-leverage and sell off some assets. This lowers their risk considerably, but also lowers the potential for profit.

On the other hand, when rates are stable and predictable, the mortgage REITs increase their leverage and collect a consistent stream of profits. This could be what is about to happen, and right now could be a great time to buy in!

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Matthew Frankel owns shares of Annaly Capital Management. The Motley Fool has no position in any of the stocks mentioned. 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.

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