A high yield income opportunity

Shortly after the financial crisis in 2009, I started to buy Annaly Capital Management (NLY). For those who don’t know what NLY is about, it is a government-backed mortgage investment company, or more officially NLY   owns a portfolio of real estate related investments in the United States. The company invests in various types of agency mortgage-backed securities and related derivatives to hedge these investments. In a simple way, NLY earns the spread or difference between the mortgage rate vs the bank interest rate. It thrills when the bank interest rate is low as the spread is bigger during such times. More detailed explanation about NLY may be found here in my previous blogs (here and here). As you can imagine, it was doing great when the interest went and stayed low during 2009 through 2012. Then the expectation for higher interest rates started to emerge around 2013, which has put pressure on NLY as investors become worried about the possible decline of its profit margin. NLY has indeed started to move down since 2013 and I closed my position along with this downward movement.

 

But I think NLY is becoming a good income trade again at the moment, which may last for another 1-2 years. You see, the worry about the interest hike in the past year was quite strong but it is clearly an overreaction. Yes, the Fed has raised the interest last Dec and is still taking about possible further rate increases this year. But I really don’t believe they can do that in the near future. The US economy is quite fragile and anything else around the world is nothing but disastrous. At the moment, the worry is not about inflation but more for deflation. And we can clearly see the signal from the bond market, which is much smarter than anyone else about where the interest rate may go. The 10 year Treasury yield has been below 2% for many months and I suspect we may likely not see higher than 2% for quite some time. I even think it may continue to go down further if the risk of recession become intensified. In this area, no one is better than Jeff Gundlach, the Bond God. I vividly recalled his prediction last summer at CNBC when the Treasury was over 3% that he did not believe the interest rate could go up but rather it would go down towards 2% by year end of 2015. Now we know what has happened about his prediction. Gundlach continues to believe the interest rate will stay low for very long time. This will be great for NLY and interestingly xx is also buying NLY now! You see, the relentless selling has pushed NLY down quite significantly and it is now below its book value by 13%. With this huge discount, its dividend yield has jumped to 11%. I don’t think this is risky high yield income. Buying NLY here should be relatively safe but always protect yourself by placing a stop around its recent low. This way, if we are wrong about this speculation, we can get out with a relatively small loss. Otherwise, we can enjoy a 11% income yield plus potential capital gains from its discount in the next 1-2 years.