Annaly: 'Quintessential income stock'

The highest-yielding stock in our portfolios, Annaly Capital Management (NLY), is yielding in excess of 11 percent. This mortgage REIT is in fact a quintessential income stock.

Since its 1997 IPO, Annaly has dramatically outperformed both the S&P 500 and the financial sub-index. With returns having come mostly from dividends, the main question concerns their future safety.

This is not as simple as it might seem at first glance. Most important, for a high-yielder like Annaly, we must consider the expectation (or lack thereof) for the dividend per share to remain stable. After two dividend cuts in 2012, this question is key.

But what we must also include in the decision to buy the stock (or not) is the relative attractiveness of the dividend in this market – even given potential for further declines – and whether the current price justifies buying these shares now.

Since its IPO, the company has paid over $9 billion in dividends, but it has not maintained consistent year-on-year growth in total payouts. As could be expected, the stock price generally reacted badly in years that it paid smaller sums.

This was also the case last year, as the company's earnings fell, and it cut its dividend (from $0.57 to $0.45 quarterly) during the year. The untimely death of the company's founder and CEO didn't help the stock's performance either.

Having said all that, we believe, the current stock price justifies further purchase — even though Annaly's quarterly dividend is likely to decline to $0.35 (a cut also generally anticipated on Wall Street). The fact is, the resulting 9 percent yield would still be attractive.

And were the stock price itself also to fall further, we expect it to eventually recover, given the rarity of such high, generally healthy yields.

The company owns and manages a portfolio of mortgage-backed securities. It generates net income to distribute to stockholders from the spread between interest income on its investment securities and the costs of borrowing to finance acquisition of investment securities—and from dividends received from subsidiaries.

Its portfolio, to date, has been almost entirely invested in U.S. government agency mortgage-backed securities and debentures, a lower-risk (but also lower-yield) mortgage market sector than others.

Annaly finances its acquisitions via net proceeds of equity and convertible note offerings — as well as borrowings under repurchase agreements according to changes in short- term rates on cash and notes. Consequently, the company is very sensitive to interest rates.

Rising long-term rates can be expected to raise returns on new investments and lower prepayments (and lower prepayment risk); meanwhile, the portfolio's book value will likely decline.

If short-term rates were to rise, financing costs would also increase. In 2012, Annaly's net interest rate spread fell from that it enjoyed in 2011 (1.29 percent vs. 2.09 percent).

But the company's investments do reside in a relatively lower-risk real estate market segment – a plus for us. Also, the company maintains only moderate leverage (at the end of 2012, Annaly's debt-to-equity ratio was 6.5:1).

Plus, the company is repurchasing stock: it has authorization to buy up to $1.5 billion worth of outstanding common shares (and in the first two months this year, it purchased some $400 million); this will further support the share price. Therefore, it remains a recommendation at its current levels.