Annaly Capital Management, Inc. (NLY), Crexus Investment Corp (CXS): Will Diversification Help This Mortgage REIT?

Prepayment risk remains for the majority of agency mortgage REITs, but Annaly Capital Management, Inc. (NYSE:NLY)’s peer company CYS Investments Inc (NYSE:CYS) has made a smart move by focusing on 15-year fixed rate securities. These securities are not immune to prepayment risk, but have much lower risk in comparison to 30-year fixed rate notes, which Annaly is mostly holding. In the first quarter, CYS Investments Inc (NYSE:CYS)’ average CPR was 17.5%, but it dropped to 13.4% at the end of the quarter. It reported that in April CPR further dropped to 12.1%. Looking at lower prepayment risk, CYS Investments Inc (NYSE:CYS) has also bought 30-year fixed rate securities, as these have a higher spread of 1.5% against the 1.2% of the 15-year fixed rate securities. With lower prepayment risk and a recent portfolio shuffle, CYS Investments Inc (NYSE:CYS) will see increased earning in future.

Diversification – a key to success?

Annaly Capital Management, Inc. (NYSE:NLY) recently announced that it will complete its merger of Crexus Investment Corp (NYSE:CXS) on May 23rd. Annaly already holds around 12.4% of Crexus Investment Corp (NYSE:CXS) . This merger will expand its portfolio from agency MBS to non-agency MBS and commercial mortgage loans. Crexus Investment Corp (NYSE:CXS) has around $1 billion of assets, which are focused on commercial mortgage. This merger is considered to be the beginning of a transformation process, as over time, Annaly will transform itself into a hybrid REIT, which includes both agency and non-agency MBS. Annaly can invest up to 25% of its equity into non-agency securities and, even after this merger, Annaly will only have around 6% of its equity allocated in non-agency assets. So there is still room for additional investment into non-agency assets. On the other hand, Crexus Investment Corp (NYSE:CXS) will have more capital flexibility and prepayment, which Annaly would be getting from agency assets, but the company will be invested in commercial assets. It is estimated that this merger will add in EPS of around $0.10.

Bottom line

With the Federal Reserve active in the market, there is very little chance that yields will improve in the near future. However, Annaly’s merger with Crexus Investment Corp (NYSE:CXS) will enhance its portfolio of non-agency assets and reduce its prepayment risk. Also, Crexus Investment Corp (NYSE:CXS) will enjoy greater availability of funds. Overall, this merged entity will reflect increased earnings in the future. Hence, I recommend holding Annaly’s stock, considering its good dividend yield of 11.8%.

The article Will Diversification Help This Mortgage REIT? originally appeared on Fool.com is written by Madhu Dube.

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