As market fear (as measured by the VIX) has been rising again (as fear of a big second wave of coronavirus rises), so too has the upfront premium income in the options market been rising, particularly for mortgage REITs. This report shares a compelling option trade that generates high upfront income and gives you the chance of owing shares of an outstanding mortgage REIT with attractive agency-backed MBS at a compelling lower price. We believe this is an attractive trade to place today and potentially tomorrow, as long as the underlying stock price doesn’t move too dramatically before then.
The blue line in the chart above is the 1-year total return of mortgage REIT Annaly Capital (NLY), the orange line in mortgage REIT AGNC Corp (AGNC).
The Trade: Annaly Capital (NLY)
Sell Put Options on Annaly Capital (NLY) with a strike price of $6.00 (~7.8% out of the money), and an expiration date of July 17, 2020, and for a premium of $0.14 (this comes out to 28% of extra income on an annualized basis, ($0.14/$6.00 x (12 months, annualized). This trade not only generates attractive income for us now, but it gives us the possibility of owning shares of NLY at an even lower price if the shares fall even further than they already recently have, and they get put to us (and we’d be happy to own NLY, especially if it falls to a purchase price of $6.00 per share).
(note: investors might also consider implementing a similar trade on AGNC Corp (AGNC) another mortgage REIT with an even higher percentage of agency back MBS on its balance sheet)
Your Opportunity:
We believe this is an attractive trade to place today and tomorrow as long as the price of NLY doesn't move too dramatically before then, and as long as you’re able to generate annualized premium (income for selling, divided by strike price, annualized) of approximately 20-25%, or greater.
Our Thesis:
Our thesis is basically that the Annaly management team is taking the the right steps to prudently manage the business through the current crisis (which is largely a short-term fear and liquidity crisis), and the company’s book (the mortgage assets on their balance sheet) positions them very well to come out on the other side of this crisis very healthy. Specifically, ~93% of Annaly’s investments are agency backed mortgage securities. These securities are backed by the US government agencies that issue them (Freddie, Fannie) and their is virtually no chance that they default. Despite the ongoing panic and fear in the bond market, Annaly is healthy (especially compared to other mortgage REITs that hold mostly non-agency MBS). Furthermore, management continue to be transparent about book value and prudent with the dividend. Specifically, management announced 2-weeks ago that they would be trimming the dividend by 12% (prudent, wise) and that they see Q2 earnings clearly exceeding the dividend (also a good thing). Overall, Annaly will make it through this bond market crisis in a healthy fashion, and the shares are trading way too low relative to book value and the company’s future earnings (and dividend power). Annaly simply should not be trading this low. For more information, you can read our previous full report on Annaly here.
Important Trade Considerations:
Please also keep in mind, options contracts trade in lots of 100, so to secure this trade with cash (in case the shares get put to you and you have to buy them) you’ll need to keep $6 times 100 on hand (the strike price times an options contract lot of 100). You’ll also need to be comfortable holding that many shares in your account from a position-sizing / risk management standpoint (Annaly’s low share price makes this trade easier to enter at a lower total dollar amount). Alternatively, if your account is approved for margin (borrowing) you don’t need to keep the cash on hand in case the shares get put to you, just know that if they do get put to you—you’ll buy them “on margin” and get charged the borrowing interest rate in your account (some investors are okay with this, others simply prefer to keep the cash on hand) if you don’t have enough cash in your account to settle up.
Two additional considerations when selling put options are dividends and earnings announcements because they can both impact the share price and thereby impact your trade. In this particular case, earnings is largely a non-issue because NLY isn’t expected to announce earnings again until August 1st (after this contract expires). However, NLY does go ex-divided on June 29th (before this contract expires). This will impact the share price and the option trade, however given the large upfront premium income and the relatively low strike price, we are comfortable with this trade.
Conclusion:
NLY has a healthy MBS balance sheet, despite the extreme gloom and doom in the news cycle. Further, the US Fed has taken a “whatever it takes” attitude in freeing up liquidity in the bond markets (particularly the markets NLY plays in) and this will ultimately help improve bond prices and NLY’s share price too. Also, Annaly has repurchased over $100 million of common stock to date during the second quarter of 2020, which is another very good sign regarding management’s view of the stock (i.e. the shares are undervalued in the market, temporarily).
If you are uncertain about pulling the trigger on a normal buy order, you might consider this trade instead. It allows you to generate attractive upfront premium income that you get to keep no matter what. And this options trade also gives you a chance of picking up shares of this attractive long-term mortgage REIT at an even lower price, if the shares fall even further than they already have, and they get put to you at $6. And at a price of $6, Annaly Capital is an extremely attractive long-term dividend investment.