As the economy recovers from COVID-19-related disruptions, investors are beginning to pay a lot more attention to the Federal Reserve and how its actions will affect their portfolios. Nowhere is this more of a concern than in the mortgage real estate investment trust (REIT) space, where companies like Annaly Capital (NLY 1.33%) are positioning themselves for when the Fed starts to reduce its purchases of mortgage-backed securities. Annaly recently reported second-quarter earnings and gave an update on how it is preparing for the end of Fed asset purchases. 

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Mortgage REITs have a different business model

Annaly Capital is a mortgage REIT, which is different than the more traditional REIT. Most REITs follow a landlord/tenant model where the REIT develops a property and then rents out the units. Its profit margin is very roughly the difference between what it pays in interest and its rental income. Mortgage REITs don't invest in real estate; they invest in real estate debt (in other words, mortgages). Their profit margin is the difference between the interest they earn on their mortgage portfolio and what they pay in interest on their borrowings. 

Annaly Capital invests primarily in mortgage-backed securities that are guaranteed by the U.S. government (aka agency securities). Most mortgages originating in the United States fall into this category. If you recently refinanced your mortgage, your loan was probably packaged into a security that resembles the ones that Annaly holds. If you get into trouble and are unable to make your mortgage payments, Annaly will still get the payments it is owed. 

Fed fears dent Annaly's portfolio value

While these mortgage-backed securities are guaranteed by the government, they aren't risk-free. Last quarter, Annaly reported a 6.5% decline in book value per share, which was due to mortgage-backed securities underperforming Treasuries. In the vernacular of the investment community, mortgage spreads (the difference between the yield on a mortgage-backed security and Treasuries) increased or "widened." What caused this to happen? Worries about the Fed. 

One of the tools in the Federal Reserve's quiver is quantitative easing, where the bank buys Treasuries and mortgage-backed securities in order to stimulate the economy. The Fed did this during the Great Recession and once again when the economy was struggling in response to the coronavirus pandemic. Now that the economy is recovering, investors recognize that the biggest buyer of mortgage-backed securities will begin to pull back. This caused investors to sell mortgage-backed securities, and that selling translated into a drop in book value per share. 

Annaly has portfolio diversification

Annaly employs different investment strategies that will perform better in different economic environments. The agency portfolio is designed for defensive characteristics (one reason why mortgage REITs are good candidates for an income portfolio). If the economy struggles, investors will flock to safer assets such as government-guaranteed mortgage-backed securities. Annaly's credit portfolio is composed of loans that are not guaranteed by the U.S. government, and those will outperform when the underlying economy is strong. 

Annaly is making an aggressive push into direct mortgage lending, which is a similar business model to New Residential (RITM 1.60%). Annaly is focusing on making loans to borrowers who don't qualify for the traditional mortgages issued by Fannie Mae or Freddie Mac. These loans are called nonqualified mortgages, and they are not guaranteed by the U.S. government, and that means Annaly is taking credit risk. These loans are nothing like the subprime loans of 15 years ago, and are often targeted toward professional real estate investors. 

During the second quarter, Annaly reduced its holdings of government-guaranteed mortgage-backed securities by about 4.5% and increased its holdings of non-government-guaranteed securities by 45%. This change makes sense in the overall economic backdrop of accelerating economic growth and rapidly rising house prices. Rising home prices mean that loans become safer, since borrowers are unlikely to default on a home where they have substantial equity. This helps support the valuation of the credit book. 

A dividend yield that isn't too good to be true

Annaly Capital is one of the few stocks with a double-digit dividend yield, which makes it an attractive stock for many income investors. While a double-digit yield is often a sign of trouble for most stocks, it is not the case for mortgage REITs. At current levels, Annaly's $0.22 quarterly dividend works out to be a 10.4% yield. Mortgage REITs generally trade right around book value per share, and book value tends to rise slowly (however, it can fall in a hurry!). The entire mortgage REIT space will have a cloud over its head as we await the Fed's exit from the MBS market. Investors who are willing to wait it out are certainly being paid to wait.