Mortgage real estate investment trusts (mREITs) Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) use similar strategies to create those double-digit dividend yields shareholders love: Borrow short-term, and buy longer-term securities, earning the difference between what it costs to borrow, and the yield on securities. This is referred to as the net interest rate spread.

While this strategy has proven, at times, to be wildly successful, interest rates have a history of raining on the parade. While interest rates have an effect on nearly everything mREITs do, their impact on asset value, borrowing costs, and net interest rate spread are three of the most important.

Rising and falling rates
More than 85% of Annaly and American Capital Agency's assets are residential mortgage-backed securities, RMBSes -- or pools of residential housing debt. Roughly 95% of those securities have a fixed interest rate -- the rate stays the same even if interest rates rise or fall. Though, that doesn't mean interest rates don't impact these securities.

The amount of cash flow an RMBS is expected to generate is fairly fixed. The amount someone is willing to pay for that return, however, will change based on perceived risk and prevailing interest rates. If interest rates rise, the price, or value, of Annaly and American Capital Agency's existing securities will decrease. In turn, this increases the securities yield. The opposite happens if interest rates fall. 

This can be seen in the chart below -- 100 basis points equals one percentage point. 

Interest Rate Sensitivity

Source: Company filings.

Falling rates seem to paint a better picture than rising rates. However, falling interest rates often encourage homeowners to refinance their mortgages, and this increases prepayment on loans. The faster the security matures the less it will ultimately yield. Moreover, since interest rates have fallen, the two companies are forced to buy into a lower yielding market.

There are positives and negatives that come from both rising and falling rates. All things equal, though, mREITs benefit more -- at least in the short term -- from falling rates as compared to rising rates. 

Borrowing costs
Annaly and American Capital Agency use repurchase agreements, or REPO loans, to buy RMBSes. The two companies sell securities to a lender with an agreement to repurchase them at a later date. The lender buys the securities at a discount, or "haircut", and charges a small interest rate, and the loan is eventually bought back at the agree upon time at full face value.

Since both companies purchase RMBSes from Fannie Mae and Freddie Mac, their securities are not at risk of default. Because of this, Annaly and American Capital Agency receive very favorable short-term interest rates. 

However, the lender's chief concern is making sure it doesn't lose money. So, if the value of pledged securities decreases -- due to increases in prepayment or rising interest rates -- the lender may "call" the loan early. This forces the borrow to pledge additional assets to cover the loan. 

The more assets it takes to cover the same loan, the less they're able to borrow, and the fewer RMBSes they're able to buy. 

The yield curve
The longer you lend money, the higher interest rate you should expect. At times, however, the "yield curve" will flatten. Meaning, the difference between short-term and long-term interest rates -- for instance, 10- and 2-year Treasury bonds -- will have the same, or similar, yields. In extreme cases, the yield may invert, and short-term borrowing is more expensive than longer term.

This is Annaly and American Capital Agency's worst nightmare. A squeezing of the yield curve shrinks their net interest rate spread. This is something we've seen over the last few years as short-term borrowing costs remained near lows, and the yield on long-term securities decreased. 

Net Interest Rate Spread Nly Agnc

Source: Company filings.

American Capital Agency wasn't founded until 2008. However, the yield curve nearly inverted during the housing bubble in 2005 to 2006, and the chart shows the strain that had on Annaly's net interest rate spread. After the financial crisis, the yield curve steepened significantly, boosting mREIT returns. 

The next step 
There isn't a whole lot of secret sauce in the mREIT sector. Mortgage-backed securities aren't proprietary, and banks don't give special rates to the company that's been around the longest. The special sauce is the management team's ability to limit the risks interest rates pose. For investors, understanding these risks is the essential first step. The next step, however, is determining the companies strategy for combating these challenges.

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.

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