The macroeconomic discussion these days is dominated by talk about inflation and the actions of the Federal Reserve to reduce it. Futures contracts based on the fed funds rate estimate that the central bank will boost the benchmark interest rate to between 1.5% and 2% by the end of the year from its current near-zero level, which is some significant tightening.
Real estate investment trusts (REITs) are highly sensitive to interest rates given that they generally use a lot of borrowed money. Historically, mortgage REITs have provided some of the best dividend yields out there, but it's looking like there are rough waters ahead. Here is how Annaly Capital (NLY 0.59%), one of the top names in this space, will likely navigate those waters.
Image source: Getty Images.
The past two years have been tough for mortgage REITs
Most REITs invest in real estate (say, an apartment complex, office building, or mall) and then rent out individual units. Mortgage REITs don't buy properties directly -- they buy real estate debt. Instead of earning rent, they earn interest.
The COVID-19 pandemic has not been kind to the mortgage REIT space. At the beginning of the pandemic, liquidity dried up in the mortgage-backed securities (MBS) market, and the REITs were subject to margin calls. Many were forced to unload investments at bargain-basement prices in order to raise cash. Eventually, the Federal Reserve started supporting the MBS market via quantitative easing, which alleviated most of the pressure.
The Federal Reserve is returning to a more normal policy
Now that the worst economic effects of the pandemic are behind us, the Federal Reserve is beginning to move its fiscal policy toward a more normalized, non-emergency posture. This involves raising the fed funds rate, but it also means ending its purchases of mortgage-backed securities and gradually reducing its massive balance sheet. That shift has been weighing on the mortgage-backed securities market, as investors fear that it will mean lower MBS prices going forward. In market parlance, this means mortgage-backed securities spreads are widening.
Widening MBS spreads during the fourth quarter dinged up Annaly's book value per share, which fell from $8.39 to $7.97. And the spread-widening trend has continued into the new year.
Annaly is making adjustments to its portfolio that it hopes will offset some of the effects from the change in Fed policy. First, it's deleveraging -- i.e., reducing its reliance on borrowed money. Second, it's reducing its holdings of agency mortgage-backed securities, which are guaranteed by the government, and buying loans that are not guaranteed by the government. Those non-guaranteed loans earn higher rates and are less sensitive to the Fed's actions than agency mortgage-backed securities are. Finally, Annaly is investing in mortgage servicing rights -- an esoteric asset class that increases in value as interest rates rise.
Investor takeaway
Annaly's stock price was just starting to get back to levels it was trading at before the pandemic hit and reached $9.64 a share in early June 2021. Since then, the stock price has fallen about 26% as rumors of growing inflation turned into proof of growing inflation.
At current levels, Annaly stock is trading at a 9% discount to its end-of-2021 book value per share. In addition, it just declared another $0.22 per-share dividend, which at today's share price gives the stock a yield of 12.4%. The company had earnings available for distribution of $0.28 per share during the fourth quarter, so its effective payout ratio is 78%, which is high, but not unsustainable for a REIT. Income investors might find the yield attractive. However, the Fed will make the next year a rough ride for the stock.
