The past 12 months have been a period of massive change for mortgage real estate investment trusts (REITs). The COVID-19 pandemic caused a major crisis initially, and then interest-rate volatility and margin calls became the defining characteristic of the environment. Most mortgage REITs, including Annaly Capital Management (NLY -0.21%), have more or less recovered from the crisis and are now looking at a new recovery-driven environment. So as the U.S. economy enters its recovery phase, investment themes change, as well. Even a mortgage REIT will find old opportunities fade and new ones appear. Here's how Annaly is adjusting its portfolio from a defensive posture to one more focused on economic growth.

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Annaly made some strategic adjustments to its portfolio

Compared to most of its peers, Annaly has historically selected from a wider menu of investment alternatives. For a mortgage REIT, these alternative investments include non-guaranteed residential loans, non-traditional mortgage loans, credit risk transfer securities, and commercial loans. Annaly has always had an active presence in loans geared toward real estate professionals, especially rental loans and "fix and flip" loans. 

While most of Annaly Capital's portfolio is in agency mortgage-backed securities (that is, securities that are guaranteed by the U.S. government) it increased its exposure to credit (in other words, non-guaranteed loans and securities) from 22% to 27% during the quarter. Annaly purchased $910 million worth of non-guaranteed mortgage-backed securities and $467 million of loans. 

Annaly sees opportunities in the non-qualified mortgage (non-QM) space and has become an aggressive bidder in this market. In addition, the company mentioned the opportunity in the agency investor market, which was driven by government policy changes. Investor loans had long been a profitable business for Fannie Mae and Freddie Mac, and the government decided to limit the number of loans they can purchase. Fannie and Freddie's loss should be Annaly's gain. 

Annaly also increased its exposure to mortgage servicing rights (MSR), which are an unusual asset that increases in value as interest rates rise. Mortgage servicers handle the administrative duties of the loan, and in compensation, they earn 0.25% of the unpaid principal balance per year. MSRs are a natural hedge and also provide a positive yield, unlike most interest rate hedging products, which cost money to use.

During the first quarter of 2021, Annaly announced the sale of its commercial real estate business to Slate Capital Management for $2.3 billion. Annaly intends to redeploy that capital into residential finance, and there are a number of different assets that are being acquired.

The changes Annaly are making shouldn't be taken as a wholesale change of strategy. Annaly is still largely an agency mortgage REIT; however, it is choosing to increase exposure to products that will benefit from an improving economy. Going forward, Annaly will still maintain its high dividend yield, although if the economy sputters, it will be more exposed to defaults.

Annaly is looking fairly valued at this point

At current levels, Annaly is trading marginally above book value per share. Generally speaking, mortgage REITs tend to trade right at book value, so it rarely makes sense to reach when they are trading above book. Annaly pays a quarterly dividend of $0.22, giving the stock a dividend yield of 9.6%, which is pretty attractive. Mortgage REITs are one of the few stocks where an abnormally high dividend is not an automatic red flag.

That said, if you are looking for a spiffy-pop, you are barking up the wrong tree; mortgage REITs trade around book value and pay a great dividend. They are great for income investors. Annaly is looking fairly valued here.