How Is Annaly Capital Protecting Its Dividend?

Due to its size and its long-for-the-mortgage-REIT-industry history, Annaly is a bellwether company for the mortgage REIT industry. Its actions are, of course, pertinent to Chimera -- whose portfolio Annaly manages -- but also to shareholders of competitors like American Capital Agency.

Since Annaly and its peers make money from interest rate spreads, the specter of rising interest rates is a concern. Lower spreads could result in lower dividends (Annaly's dividend yield is still at 12.6%, despite lowering its quarterly dividend rate to $0.55 from $0.65 a year ago). Here's what Annaly CEO Michael Farrell said about the interest rate environment:

We continue to monitor and evaluate the challenges facing the Euro countries and their institutions, regulatory uncertainty about the function and structure of the global financial system and election-year brinksmanship on fiscal and tax policy. In addition, we see long-term risks related to the general direction of monetary policy and its effect on the financial markets. Our concerns about embedded risks in the markets continues to be reflected in the way we manage the Company. We believe our stance maintains our flexibility while continuing to generate attractive risk-adjusted returns for our shareholders.

Beyond the words, Annaly uses interest rate swaps to hedge its interest rate risk. Before the swaps are factored in, Annaly's portfolio of mortgage-backed securities is 92% fixed rate. Afterwards, the percentage is 51%. That's a material amount of hedging.

Lingering questions include whether that hedging will be effective and whether it will be enough (or too much, if rates stay low). Bottom line: Beyond a good knowledge of the financial mechanisms being employed, investors in mortgage REITs must trust management to invest in them.

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Anand Chokkavelu has no positions in the stocks mentioned above. Andrew Tonner has no positions in the stocks mentioned above. The Motley Fool owns shares of Annaly Capital Management. 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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  • Report this Comment On September 07, 2012, at 3:48 PM, NeuroProf wrote:

    Beyond the words, Annaly uses interest rate swaps to hedge its interest rate risk. Before the swaps are factored in, Annaly's portfolio of mortgage-backed securities is 92% fixed rate. Afterwards, the percentage is 51%.

    I don't understand what this actually means. This is the meat of the article but it is not explained. Could you please tell us more. Thanks.

  • Report this Comment On September 09, 2012, at 1:59 AM, DavidinNV wrote:

    In addition: I would like some commentary on why a rise in interest rates automatically means that spreads will narrow. Don't the changes occur at both the short end and the long end of the spectrum?

    I realize that there was actually an inversion between the short and the long ends several years ago, but even then Annaly still paid a dividend, albeit a much smaller one.

    Finally, with what is probably the lowest leverage in its universe, it seems to me that Annaly is in a better position than its competitors to leverage up if necessary to ride out some of the vagaries that may occur.

  • Report this Comment On September 09, 2012, at 1:08 PM, jonkai wrote:

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    investors in mortgage REITs must trust management to invest in them

    -----------------

    truer words have never been spoken...

    --------------------------

    This is the meat of the article but it is not explained

    --------------------------

    it means if you own fixed rate mortgages, interest rate changes effect what those mortgages are worth, and what your profit is, because if you pay more for your expenses (interest rates), your income is not... so less profits...

    (but also works in reverse)...

    to mitigate this "risk", NLY buys fancy derivatives to hedge.. (swaps)

    while "derivatives" have gotten a bad name because they basically were abused by congress not allowing departments to regulate them, and then the Goldman Sachs of the world doing the abusing... while making sure Congress was pushed and paid to make sure they were not regulated...

    how ever "derivatives" done right are a good thing... and nly spreads these around... so for instance if spain collapses... NLy only loses like 1% of it's hedges... that sort of thing...

    now how do they work? "hedges" can be thought of as insurance... you pay a premium so that someone will insure to you that an interest rate stays the same... or basically pays if the interest rate changes a certain amount....

    in this way the interest rate they pay really floats... so they are not hurt by interest rates rising... (or not hurt as much).... and about 1/2 of their portfolio is 'protected" in this way... AGNC is very young and trying desperately to catch up to paying a lot for "protection"....

    and these swaps, should be thought of as insurance... they are always going to be an expense.. if they turn into a profit... then something very very bad happened..... so it is a good thing they "lose" money on swaps every quarter... it means interest rates didn't change all that much...

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