How to Score 13% With Annaly Capital Management

Unless some Annaly trader screws up, the good times will continue to roll for the real estate investment trust -- at least through 2013.

The concept behind Annaly Capital Management (symbol NLY (opens in new tab)) is so simple it deserves a hundred imitators and a reputation as grand as Bill Gross's. But Annaly, a real estate investment trust that owns a $113 billion portfolio of mortgage securities, remains obscure, despite a 13.3% dividend yield and an annualized return of 15% over the past five years.

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Both of those figures are remarkable. Over the past five years, the U.S. stock market has been flat. And a double-digit yield, at a time when Treasuries pay 2% and money market funds pay nothing, is stupendous. Indeed, in an age of rampant financial-figure finagling, an investment paying 13% bears close inspection.

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My conclusion, reached after consulting people who know Annaly, is that its dividend is honest, covered by actual cash flow. Yes, there are risks, but they're unlikely to materialize for years. Unless some Annaly bond trader screws up spectacularly, the good times will continue to roll, at least through 2013. Look for Annaly to trim a few pennies from its quarterly dividend of 57 cents, but the payout and yield will stay so high you won't miss them. And there's no reason Annaly's stock—about $17 in early February—can't remain in a fairly narrow price range over the next couple of years (the shares traded between $14.05 and $18.79 over the past year).

As a REIT, Annaly, which was founded in 1997, is required to distribute 90% of its earnings as dividends. Its formula is to borrow at short-term rates (currently, it has $5 of debt for every dollar of its own capital, although it can leverage as high as 12 to 1) and invest the money in government-backed pools of fixed-rate mortgages, such as Ginnie Maes. It's a great strategy when the cost of borrowing is less than the income from the loans and ample credit is available.

Bernanke's gift. Danger arises when the gap between borrowing costs and income shrinks (or threatens to shrink). But Federal Reserve chairman Ben Bernanke has just given Annaly a golden gift. His vow to hold short-term rates near zero until 2014 ensures a supply of low-cost fuel to feed Annaly's earnings engine.

The mystery of Annaly, however, isn't how it makes its money. It's why the market prices its shares to yield so much more than junk bonds, even though nearly all of Annaly's assets are guaranteed by the U.S. government and its few stumbles have been minor.

I sought out members of Annaly's brain trust, but they declined to answer my calls. Many executives avoid speculating about why the market assigns this or that value to their stock. Or perhaps the Annaly brass have no time. In January, Annaly announced that its founder and CEO, Michael Farrell, has cancer, though it's treatable and he's staying put.

But investors who know Farrell vouch for his talents and express confidence that he and his team won’t get greedy or careless. Moreover, my sources say, not just anyone could have run Annaly so skillfully for so long or could have successfully navigated through the 2008 credit panic, which killed several other mortgage REITs. "This is a classic case of betting on the jockey and not just the horse," says Ron Sorenson, chief investment officer of Reaves Asset Management, a Jersey City, N.J., firm that owns Annaly in Reaves Utility Income, a closed-end fund, and in other accounts.

Sorenson says Annaly's yield is inflated because bearish analysts expect the REIT's profit margin to shrink as homeowners refinance into lower-rate loans. But it's hard to see, given the expected pace of refis, how this could hurt Annaly significantly in the short term. Another Annaly fan, Steve Carhart, of Trust & Fiduciary Management Services, in Boston, says the stock market questions the Fed's ability to keep short-term interest rates near zero indefinitely. Another challenge would occur if the economy and housing weakened so much that 30-year mortgage rates fell to 2%. Even Annaly couldn’t twist those into a decent profit.

Jeff Kosnett is a senior editor at Kiplinger's Personal Finance.

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Jeffrey R. Kosnett
Senior Editor, Kiplinger's Personal Finance
Kosnett is the editor of Kiplinger's Investing for Income and writes the "Cash in Hand" column for Kiplinger's Personal Finance. He is an income-investing expert who covers bonds, real estate investment trusts, oil and gas income deals, dividend stocks and anything else that pays interest and dividends. He joined Kiplinger in 1981 after six years in newspapers, including the Baltimore Sun. He is a 1976 journalism graduate from the Medill School at Northwestern University and completed an executive program at the Carnegie-Mellon University business school in 1978.