Worried About a Market Crash? Try These Overlooked Stocks

By Markets Fool.com

If you're tired of being pitched the same boring blue chip stocks that are supposed to protect you from a market crash, then you need to check out mortgage real estate investment trusts, or mREITs, like Annaly Capital Management .

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Unlike the S&P 500, which took a 27% loss between 2007 and mid-2009, Annaly thrived during the financial crisis. It thrived during the market crash before that, and it will thrive during the next one. Sound too good to be true? It's not.

The reason Annaly and its younger but similarly equipped competitor, American Capital Agency , have succeeded during recessions stems from the quality of their assets.

I guarantee it
Annaly and American Capital Agency manage portfolios of agency mortgage-backed securities, which are, quite simply, bonds made up of residential mortgages.

What makes these assets unique, however, is that they're essentially guaranteed against default by Fannie Mae and Freddie Mac. If homeowners can't pay their mortgages, Fannie and Freddie will step in and cover the missed payments.

More importantly, if losses pile up and either Fannie or Freddie fails, the assumption is that the U.S. government will come to their aid -- an assumption that proved true during the financial crisis in 2008 -- which makes Annaly and American Capital Agency's assets about as safe a U.S. Treasury bonds.

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The business model
To finance their investments in long-term mortgage assets, both companies make short-term borrowings, earning the difference, or spread, between what it cost to borrow and the yield on their assets.

Effective Federal Funds Rate Chart

The gray bars in the chart represent recessions, and what's interesting about those time periods is that the gap between the federal funds rate (short-term interest rates) and the 30-year mortgage rate (long-term interest rates) explodes.

Since Annaly and American Capital Agency can borrow for less and still earn a solid yield on their assets, an ideal investment environment emerges. That environment has continuously repeated itself and will continue to do so, because it's the most effective way for the Federal Reserve to manage economic growth and control inflation.

The Federal Reserve
While most economic growth is good, when demand severely outpaces supply we end up with rapid inflation. Prices increase, the buying power of the dollar falls, and because wage growth can't keep up, the cost of living skyrockets -- all of which is bad news.

To control inflation, the Federal Reserve will increase short-term interest rates -- as it did from mid-2004 to mid-2006 -- and immediately make borrowing, and therefore money, more expensive.

However, as Annaly's late CEO Michael Farrell wrote in his 2005 letter to shareholders, "Raising the fed funds rate ... is a hammer, not a scalpel, and the Federal Reserve will, as usual, go too far in using it and cause some sort of economic event that will lead to an easing of monetary policy."

What Farrell was suggesting is that while raising short-term interest rates works to calm inflation, it inevitably does its job too well and leads to a recession. This situation forces the Federal Reserve to drop the federal funds rate, make money cheap again, and help to encourage economic growth.

A closer look
It's one thing to say Annaly, American Capital Agency, or similar mREITs can perform well during a market crash. It's quite another to see it with your own eyes.

The blue line and the percentage on the right represent Annaly's net interest rate spread -- the difference between the interest rate on their borrowings and their assets. The orange bars are Annaly's annual dividend. The wider the spread, the bigger the company's dividend.

Because Annaly and American Capital Agency pay out at least 90% of their earnings to shareholders in the form of dividends, a high dividend means a big total return. In fact, between 2007 and mid-2009 -- when the S&P 500 fell 27% -- Annaly had a total return of 45%.

NLY Dividend Chart

Most importantly, if you were to overlay the first two charts it'd look like this graphic. In both instances, Annaly's dividend takes off through market crashes.

How much should I buy?
Historically, Annaly and American Capital Agency have moved in the opposite direction as the S&P 500. While this trend helps investors during recessions, it will drag on your portfolio during boom times.

With that said, if you're looking to balance out your portfolio and soften the blow from a recession, then adding even a small percentage of plain vanilla mortgage REITs, like Annaly or American Capital Agency, can go long way.

The article Worried About a Market Crash? Try These Overlooked Stocks originally appeared on Fool.com.

Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.