Booking 63.15% Gains in 5 Days — and Doubling down on Mortgage REITs

Financial markets bounced strongly the past week with the S&P ending the week 2% higher. Last week’s Dividend Pro recommendation to buy January $35 call option on Rentech Nitrogen Partners, L.P. (RNF) paid off particularly well, as the options soared 63.15%.

Sell half your options here to lock on your big, quick gains. Hold on to the rest, for potentially bigger gains in the future.

This week’s Dividend Pro recommendation — Annaly Capital Management (NLY) is another “contrarian” pick that bets on a bounce in a sector that has recently endured a sharp sell off. NLY tumbled from its 52-week highs of $17.75 on Sept. 12 and to an intraday low on Monday, Oct. 15 of $15.27. That’s a gut-wrenching fall of 14% in a little over a month.

So why the big drop?

The Federal Reserve’s new round of quantitative easing QE3, which will buy up roughly $40 billion in mortgage-backed securities each month to keep rates low on mortgage debt, is clearly to blame for Annaly’s tumble.

To understand how QE3 impacts mortgage REITs, let’s review how mortgage REITs make money.

Mortgage REITs raise capital, usually via low interest loans, and then acquire longer term mortgage based assets and profit from the spread between the two. For example, a REIT borrows money at currently ultra low short term rates (say 1%), and then turn around and invests it into potentially higher yielding real estate portfolios (say 4%).

The REIT then uses leverage to make money from the spread differential (4%-1%= 3%). If the REIT leverages that up 5 times, it makes 5 x 3% of that interest rate differential (15%). REITs then pay out these profits in the form of high yields to investors on a regular basis.

The worry is that QE3 could pull down rates of return in the REIT market (the 4% in the example above), reducing the spread (3%) or potential profits in the REIT sector.

There are two important points to keep in mind.

First, the Fed has committed itself to keeping borrowing costs low for the foreseeable future, keeping the borrowing side of the equation (1%) stable for REITs.

Second, even if the spread narrows thanks to QE3, mortgage REITs are among the biggest yielders on the market today, often yielding 11% or more. By way of comparison, Exxon Mobil (XOM) today yields just 2.5%.

That’s why I think the selling in the REIT market is overdone. And the past couple of years, buying the pullbacks in this sector due to dividend cuts or secondary stock offerings have paid off handsomely.

More importantly, NLY just announced that its board has authorized it to buy back as much as $1.5 billion worth of its outstanding common stock over a 12-month period. That’s nearly 10% of the outstanding shares based on NLY’s Oct. 16 market cap of $15.32 billion. This supports the stock’s price and compensates for a potential reduction yield reduction in the current yield.

NLY’s share buyback plan is a clever response to Q3. First, it limits the downside in the stock price. Second, since NLY will not be reinvesting in the more expensive, lower returning mortgages available today, the buyback plan should help it maintain a higher dividend in the future. In fact, there is already talk of other mortgage REITs copying NLY’s strategy.

The bottom line?

Even with QE3, NLY has plenty of ways to keep paying a generous dividend and move its share price higher. With its shares “on sale”, buy Annaly Capital Management (NLY) at market today and place your stop at $13.50.

Disclosure: I am a long-time holder of Annaly Capital Management (NLY) for my clients at Global Guru Capital.

Portfolio Update

Global X SuperDividend ETF (SDIV) jumped 2.48% this past week. You should have received your dividend of 19.5 cents per share last week. With a 12-month dividend yield of 8.92%, and now trading back above its 50-day moving average (MA), SDIV is a BUY.

Two Harbors Investment Corp. (TWO) bucked the sell-off in mortgage REITs and rose 0.68% this week. Unlike some mortgage REITS such as American Capital Agency Corp. (AGNC) and Annaly Capital Management Inc. (NLY), which invest almost solely in agency mortgage backed securities. TWO is a BUY.

American Capital Agency Corp. (AGNC) dropped 1.67%. At the same time, I expect a strong bounce for the reasons I outlined above. A dividend of $1.25 a share is payable on Oct. 26 to shareholders of record as of Sept. 21. Dropping below its 50-day MA, AGNC remains a HOLD.

Prospect Capital Corporation (PSEC) rose 3.43%.Prospect has closed more than $1.5 billion of originations to date in the current 2012 calendar year, including approximately $750 million in the September 2012 quarter. Prospect’s advanced investment pipeline aggregates more than $600 million of potential opportunities. Yielding above 10%, PSEC is a BUY.

iShares FTSE NAREIT Mortgage REIT (REM) was flat this week. Mortgage REIT ETFs will remain attractive for the reasons I’ve outlined above. Dropping below its 50-day MA, and severely oversold, REM remains a HOLD.

PIMCO Municipal Income Fund II (PML) rose 1.46%. This steady performer is back above its 50-day MA, and is now a BUY.

UBS E-TRACS 2x Leveraged Long Wells Fargo Business Development Company ETN (BDCL) rose 2.94%. BDCL will pay out a dividend of $.9169 per share on Oct. 22 for a yield of 14.13%. Trading back above its 50-day MA, BDCL moves to a BUY.

Apollo Investment (AINV) rose 0.13% after last week’s drop. Apollo Investment Corporation announced yesterday that it will report its second quarter results for the period ended Sept. 30 at approximately 7:30 a.m. Eastern Time on Thursday, Nov. 8. Yielding 10%, but still trading below its 50-day MA, AINV is a HOLD.

Omega Healthcare Investors Inc. (OHI) ended the week 1.20% higher. Yesterday, the company announced that the Company’s Board of Directors declared a common stock dividend of $0.44 per share, an increase of 4.8%.  The common stock dividend is payable Nov. 15 to common stockholders of record as of the close of business on Oct. 31. OHI also announced today that it is scheduled to release its earnings results for the quarter ended Sept 30 on Friday, Oct. 26. With the stock still below its 50-day MA, OHI remains a HOLD.

PowerShares Preferred (PGX) was flat this past week As of Oct. 3, the fund held 151 issues. The fund is based on the BofA Merrill Lynch Core Fixed Rate Preferred Securities Index. The sector breakdown is 92% financial, 5% utilities and 2% telecommunications and the rest, fractional.Yielding over 6.4%, this monthly income payer is a BUY.

Fifth Street Finance Corp. (FSC) dropped 1.01%. FSC announced a dividend of 9.6 cents per share on Oct. 11. FSC remains a BUY.

Vanguard Natural Resources (VNR) jumped 0.99%, hitting a new 52-week high. As of March 31, 2012, the company had total proved reserves of 71.9 million barrels of oil equivalent, as well as owned working interests in 1,459 net productive wells. You received a monthly dividend of $0.20 on Oct. 15 — a yield of approximately 0.70% per month. VNR is a BUY.

CVR Partners, LP (UAN) bounced another 2.71% this past week. Producing, distributing and marketing its nitrogen products and based in Texas, CVR has a robust economy to fall back on, ample natural resources in its back yard and close proximity to the Midwest. The company will release its third quarter 2012 earnings on Monday, Nov. 5, after the close of New York Stock Exchange trading. Back above its 50-day MA, UAN is a BUY.

PowerShares S&P 500 BuyWrite Portfolio (PBP) jumped 1.83%. With a 10.28% and yield, trading above its 50-day MA, PBP is now a BUY.

Rentech Nitrogen Partners, L.P. (RNF) rebounded 6.21%, jumping even more sharply than I expected, and allowed you to book a quick 63% gain in last week’s option recommendation. The fertilizer maker has delivered three straight quarters of triple-digit profit growth. Analysts are expecting another triple-digit gain when it reports Q3 results on Nov. 8. Still trading above its 50-day MA, and yielding a whopping 13.40%, RNF remains a BUY. As of March 31, 2012, the company had total proved reserves of 71.9 million barrels of oil equivalent, as well as owned working interests in 1,459 net productive wells.

UBS E-TRACS 2x Leveraged Long Alerian MLP Infrastructure Index ETN (MLPL) recovered 2.75% this past week. This ETF also paid out a $1.082 per dividend on Oct. 10. MLPL remains a BUY.