Mortgage real estate investment trusts, or mREITs, can be a tempting investment with their high dividend yields. They also come with a fair amount of risk with their high exposure to changes in interest rates, and the world has seen significant rate changes in the past year.
With today’s interest rate environment, you have to question whether or not a company like Annaly Capital Management (NYSE: NLY) is in trouble, and if this mREIT is a good investment.
About Annaly Capital Management
Annaly Capital Management is a mortgage REIT that primarily invests in agency mortgage backed securities (MBS), which are mortgage loans that are guaranteed by either Freddie Mac (OTCMKTS: FMCC) or Fannie Mae (OTCMKTS: FNMA). The company purchases these assets by borrowing money with short-term loans that have the lowest interest rates, and earning the difference between the interest they receive on the long-term loans they purchase and the interest they pay on the short-term loans.
Risks to Annaly Capital Management
Current interest rates provide almost an almost perfect environment for a company like Annaly. Long-term interest rates are increasing, while short-term rates are expected to remain low for a while longer. This means their margins increase as the interest they’re paying remains low and the interest they’re receiving on their assets increases.
So what could go wrong with a situation like this? For one, while interest rates are increasing on the 30-year mortgages the company invests in, their portfolio has to be turned over to realize those increases. This means either selling them at a discount, since the rates are lower than other MBS on the market, or waiting for borrowers to either sell, refinance, or pay their homes off early.
At some point, the spread between short-term interest rates and long-term rates is going to tighten. To protect themselves from this, the mREIT has to play this high-stakes game of rate swaps. In simple terms, this basically means that they’re betting on what rates will be at specific times in the future. If they’re right, they can continue to enjoy their wide spread. If they’re wrong, their spread could shrink even further.
Nobody can say for certain what interest rates will be in three, five, or 10 years. While companies like Annaly Capital Management hire some of the smartest expertes in the world to predict interest rates, there are too many variables for anyone to win the rate swap game every time.
The case for Annaly Capital Management
Mortgage REITs are risky, there’s no question about it. However, some of them pay pretty handsomely to take that risk. For instance, Annaly Capital Management’s dividend yield currently sits at 9.6%. Also, it appears that their bottom line should stay relatively safe for the time being since the Fed plans to keep interest rates near zero until the economy has fully recovered.
The mREIT also invests in one of the safest asset classes available, which is the agency MBS. The risk of loss is almost nonexistent because the loans are guaranteed by the federal government. They’re also extremely easy to liquidate and borrow against, so the company’s liquidity will remain strong.
The Millionacres bottom line
There’s no reason to believe that Annaly Capital Management is in any immediate trouble. The company is also in a good position to be able to work through any future troubles with the flexibility that comes with a portfolio of assets that are easy to liquidate. However, when the current yield curve flattens and their net interest margin shrinks, the mREIT’s dividends will likely become unsustainable. If you’re making room in your portfolio for Annaly Capital Management, you’ll want to be prepared to ride out a fluctuating dividend and price as the company navigates all of the stages in the economic cycle.