Annaly Capital: Buy, Sell or Hold?

If you want to generate passive income from your portfolio, Capital Annaly (NLY 0.75%) and its dividend yield of 13% is probably a stock that has appeared on the screen.

Mortgage real estate investment trusts (mREITs) allow investors to invest in the US real estate market and could be a way to invest in higher mortgage rates in the current environment. However, the stock is highly sensitive to interest rates, which have hurt the business over the past few years. If you’re considering owning Annaly because of its high dividend yield, consider the following first.

How does Annaly make money

Annaly invests in mortgage-backed securities (MBS), pools of residential mortgage loans bundled together and sold to investors. Government sponsored entities such as Federal National Mortgage Association (Fannie Mae) and Federal Mortgage Loan Corporation (Freddie Mac), guarantees the principal and interest payments on these mortgage investments, which can help mitigate the risk to some extent.

However, the company competes in a commodity-like business, competing for the same MBS as competitors, making it difficult to stand out. Also, since the yield on the mortgage loan is not high enough, the mREIT uses leverage to increase the return on its portfolio.

Annaly uses repurchase agreements (repos) and other financial instruments to stimulate and increase returns. The company aims to have a leverage ratio below 10:1, the ratio of its debt to derivatives divided by total equity.

Using equity and borrowed funds to invest in MBS allows Annaly to earn the difference between the return on its assets and the cost of its borrowings. Because it borrows short-term while investing in long-term MBS, it is sensitive to changes in the yield curve, which is the relationship between interest rates and time to maturity for an asset.

Image source: Getty Images.

In recent years, interest rates have risen along the yield curve. Last year, Annaly’s average return on its interest-earning assets was 4.33%, reflecting its investments in the higher mortgage rate environment. However, its average cost of debt was 3.01%, up from 0.79% two years earlier. As a result, the net interest margin of 1.32% was down from 1.89% in 2021.

Another way Annaly is feeling the impact of higher interest rates is in the book value of her portfolio. The book value of debt securities is sensitive to changes in interest rates. When interest rates rise, the value of these securities falls. Over the past two years, Annaly’s book value per share has fallen 39%.

Poor returns for investors

Annaly’s sensitivity to interest rates makes it vulnerable to changes in economic and market cycles. In recent years, the stock has failed to deliver for investors. Since 2018, Annaly’s total return (including the effect of dividend reinvestment) is -5.6%. So despite investors “earning” a double-digit dividend yield, the stock fell 58%, making the net yield negative.

NLY Total Return Level data by YCharts.

Long-term structural factors could lead to higher interest rates compared to the decade before the pandemic.

For example, JPMorgan Chase CEO Jamie Dimon warned that rising fiscal deficits, a restructuring of global trade, rising government liabilities and geopolitical uncertainty could make this decade more volatile than the last. Because of this, the higher interest rates make Annaly less attractive to me as a long-term investment (five years or more).

Is Annaly right for you?

That said, I think Annaly could do well if the Federal Reserve starts cutting interest rates. Conformable CME GroupFedWatch’s tool, market participants are pricing in six 0.25% interest rate cuts over the next year.

Annaly, which has increased its portfolio yield, would benefit from lower interest rates, which could help reduce funding costs in the shorter term. Falling interest rates would also boost its book value after several years of declines.

While they may do well over the next year, if interest rates start to fall, structural factors could keep interest rates high for the next decade. Given Annaly’s sensitivity to interest rates, use of leverage, and lack of a robust competitive advantage, I’d rather look elsewhere for yield.