Credit risk

Annaly Capital increases its exposure to credit risk as agency spreads widen

As the economy recovers from the disruptions related to COVID-19, investors are starting to pay much more attention to the Federal Reserve and how its actions will affect their portfolios. Nowhere is this more concerning than in the real estate investment trust (REIT) mortgage business, where companies like Annaly Capital (NLY -0.59%) are positioning themselves for when the Fed begins to scale back its purchases of mortgage-backed securities. Annaly recently released its second quarter results and provided an update on how it is preparing for the Fed’s end of asset purchases.

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Mortgage REITs have a different business model

Annaly Capital is a mortgage REIT, which is different from the more traditional REIT. Most REITs follow an owner/tenant model where the REIT develops a property and then leases the units. Her profit margin is very roughly the difference between what she pays in interest and her rental income. Mortgage REITs do not invest in real estate; they invest in real estate debt (ie mortgages). Their profit margin is the difference between the interest they earn on their mortgage portfolio and what they pay in interest on their borrowings.

Annaly Capital invests primarily in mortgage-backed securities that are guaranteed by the US government (aka agency securities). Most mortgages originating in the United States fall into this category. If you recently refinanced your mortgage, your loan was probably wrapped in a title that looks like the ones Annaly has. If you run into trouble and are unable to make your mortgage payments, Annaly will still receive the payments owed to her.

The Fed fears it will reduce the value of Annaly’s portfolio

Although these mortgage-backed securities are guaranteed by the government, they are not without risk. In the last quarter, Annaly reported a 6.5% decline in book value per share, due to underperformance in mortgage-backed securities and Treasury bills. In the vernacular of the investing community, mortgage spreads (the difference between the yield on a mortgage-backed security and Treasuries) have increased or are “widening”. What caused this? Concerns for the Fed.

One tool in the Federal Reserve’s quiver is quantitative easing, where the bank buys Treasuries and mortgage-backed securities to stimulate the economy. The Fed did this during the Great Recession and again when the economy was struggling in response to the coronavirus pandemic. Now that the economy is recovering, investors recognize that the biggest buyer of mortgage-backed securities will start to pull back. This caused investors to sell mortgage-backed securities, and this sale resulted in a decline in book value per share.

Annaly has portfolio diversification

Annaly uses different investment strategies that will perform better in different economic environments. The agency portfolio is designed for defensive characteristics (one of the reasons why mortgage REITs are good candidates for an income portfolio). If the economy is struggling, investors will flock to safer assets such as government-backed mortgage-backed securities. Annaly’s credit portfolio is made up of loans that are not guaranteed by the US government, and these will outperform when the underlying economy is strong.

Annaly is aggressively pushing into direct mortgages, which is a similar business model to New Residential (RITM -0.79%). Annaly focuses on providing loans to borrowers who do not qualify for traditional mortgages issued by Fannie Mae or Freddie Mac. These loans are called non-qualified mortgages and they are not guaranteed by the US government, which means that Annaly takes on credit risk. These loans are nothing like the subprime loans of 15 years ago and are often aimed at professional real estate investors.

During the second quarter, Annaly reduced its holdings of government-guaranteed mortgage-backed securities by approximately 4.5% and increased its holdings of non-government-guaranteed securities by 45%. This change makes sense in the general economic context of accelerating economic growth and rapidly rising real estate prices. Rising house prices mean loans are becoming safer, as borrowers are unlikely to default on a home where they have substantial equity. This supports the valuation of the credit portfolio.

A dividend yield that’s not too good to be true

Annaly Capital is one of the few stocks with a double-digit dividend yield, making it an attractive stock for many income investors. While a double-digit return is often a sign of trouble for most stocks, this is not the case for mortgage REITs. At current levels, Annaly’s quarterly dividend of $0.22 corresponds to a yield of 10.4%. Mortgage REITs typically trade around book value per share, and book value tends to rise slowly (however, it can fall quickly!). The entire mortgage REIT space will have a cloud over its head as we await the Fed’s exit from the MBS market. Investors who are willing to wait are certainly paid to wait.