Annaly Capital Management (NYSE:NLY) is a mortgage real estate investment trust (REIT), which differs from the more traditional REITs that manage office or retail properties. These other REITs generally buy properties like buildings and strip malls and make their money from rental income. Mortgage REITs have a different strategy: They are pure investors, buying financial instruments such as mortgage-backed securities, and making their money on the interest that these instruments pay.

Historically, mortgage REITs have tended to focus on buying mortgage-backed securities that were issued by either Fannie Mae or Freddie Mac. These securities are guaranteed by the U.S. government, which means there is no risk to investors that they won't get paid. If one of the underlying mortgages defaults, the mortgage insurer or the government will make the payments. So from an investor's standpoint, the only risk is interest rate risk.

So how are mortgage REITs like Annaly able to pay such a high dividend yield on what would otherwise be considered low-risk investments? Read on.

Picture of interest rates table

Image source: Getty Images.

Interest rate risk versus credit risk

It's helpful to think of all bonds as sitting on a continuum of interest rate risk and credit risk. A 10-year Treasury note has no credit risk (the risk of issuer default is tiny because the government owns the printing press), so it moves based solely on the vagaries of the bond market.

On the other end of the spectrum, a corporate bond with a very low credit rating will be insensitive to the day-to-day movements of the bond market and will be driven by news flow. The higher the risk, the higher the implied yield.

A mortgage-backed security may yield 2.5%, while a distressed corporate bond could yield 25% or more. 

Leverage is the way REITs supercharge returns

Annaly has a portfolio of agency mortgage-backed securities (MBS), and this has historically been the REIT's bread-and-butter way of generating return. You may be asking how a company that invests in mortgage-backed securities earning 2.5% can manage to generate a dividend yield of 10%. The answer: leverage. Annaly borrows money to build a portfolio.

Leverage is no different in theory than using margin to buy a stock. The upside is magnified and so is the downside. Unlike stock market investors who are limited by Regulation T to no more than 50% leverage, Annaly has no such restriction. Mortgage REITs will generally use somewhere between 500% and 900% leverage. Leverage increases interest rate risk (and mortgage-backed securities have a lot of it), so managing that risk requires sophisticated analysis, and unexpected moves by the Fed can have outsize effects on the portfolio. 

How Annaly constructs a portfolio that works over the entire economic cycle

By diversifying into more credit-based risk (in other words, buying securities that carry risk of default), Annaly is reducing its interest rate risk in the portfolio. These securities have a higher yield, so it requires less leverage to generate an acceptable return to stockholders. Annaly's credit portfolio is much smaller than the agency MBS portfolio; however, the businesses have similar leveraged returns.

The businesses also perform best in different parts of the economic cycle. The traditional agency MBS portfolio does best in a deteriorating economy when investors are selling risky assets to buy safe ones. On the other hand, commercial real estate is cyclical -- when the economy is in good shape, rents increase and defaults fall. Annaly's residential portfolio, which consists of non-guaranteed mortgage-backed securities and whole loans, is also cyclical, but it benefits from a strong supply-demand imbalance in residential property. Finally, the mid-market lending sector is less economically sensitive overall. 

While it looks like the immediate economic environment will be relatively benign with the Fed on hold, Annaly will be positioned for continued growth. The countercyclical nature of the core agency MBS portfolio should perform well even if we hit a recession. If the economy takes off from here, the commercial real estate portfolio will perform well.

In other words, Annaly has positioned itself to support its 10% dividend yield in all economic environments. That makes it a REIT worth paying closer attention to and potentially investing in.