Treasuries have found their footing again over the past week, rallying back to near the highs of the year. Long-term Treasuries remain in an uptrend:
While Treasuries have moved higher, we don’t have a strong directional view given the various push/pull factors affecting the market. The Fed’s exit from QE is one demand source that is out of the picture, but investors have actually moved towards Treasuries in times of no QE over the past 5 years because economic growth concerns have re-surfaced. We might be seeing a similar script play out.
While we don’t care much for trading Treasuries at the moment, Annaly, NLY, is a mortgage REIT that we traded successfully earlier this year on the back of a move lower in long-term rates. This was the trade rationale at the time:
While the risks for NLY are clear, the stock’s low implied volatility could offer an opportunity for a defined-risk way to play for upside over the next 6 months, likely a better way to play for lower rates than buying Treasuries or the stock itself.
NLY touched a 6 month low yesterday as investors have rapidly rotated out of REITs over the past month:
This has occurred even as Treasuries have generally remained bid. As I discussed in a CotD post in July, NLY’s fundamental valuation is starting to look attractive on the selling:
The stock has sold off nearly 4% this week, and is now trading at a Price / Book ratio of 0.90. If that ratio nears 0.85, we might look at a longer dated long call position in the stock once again. Options pricing remains relatively cheap, particularly considering that interest rate volatility remains higher than stocks. 30 day implied vol in NLY:
Of course, NLY won’t find much footing if rates continue higher from here. At the moment, we’d rather watch and see how rates react over the next month, but if they stabilize even with the strong economic data, we might get involved on the long side in NLY calls once again.
NLY’s recent selling has taken book value down to 0.82x, which is near long-term lows for NLY, and a reflection of investor distaste for long-term bond duration:[caption id="attachment_46190" align="aligncenter" width="600" class=" "] NLY Price / Book ratio, courtesy of Bloomberg[/caption]
In a Deep Dive post in February, I detailed NLY’s portfolio strategy, which is essentially to invest in long-dated agency mortgage bonds. As a result, long-term interest rate risk is the main concern, particularly when NLY is already trading below book value.
Yet, low implied volatility is at a disconnect with the stock’s low fundamental valuation. While volatility has risen in the last month, it is still at the low end of the 2 year range:[caption id="attachment_46191" align="aligncenter" width="600" class=" "] 30 day implied volatility in NLY, courtesy of Bloomberg[/caption]
With this backdrop, I like the idea of playing for a move higher in NLY over the next few months with call options as opposed to buying the stock. If long-term rates do move higher, then NLY could see more weakness, but if long-term rates are flat or move lower, then NLY is a cheap stock with a good bit of potential upside and cheap call options to boot.
That asymmetric risk/reward led me to purchase the following position:
Trade: NLY ($10.92) Bought the Apr 11 Call for $0.42
Break-Even on April Expiration:
Profits: above 11.42
Losses: below 11.42, with total loss at 11 or below
Given the cheap premium in NLY, we’d rather look to participate in a potential break higher with a 6 month call option, rather than buying the stock here. Earnings are in early November. Be aware that one reason for the cheap premium is that NLY has two 0.30 dividends between now and April expiration, which is going to hit the stock down 0.60 in total between now and July. Even with that though, we view the options as quite attractive for asymmetric risk/reward. We only need one quick rally over the next 6 months to have a nice winner on our hands.