The past year has been terrible for mortgage real estate investment trusts (REITs) in general. The Federal Reserve has been buying mortgage-backed securities since the early days of the COVID-19 pandemic, which has helped bolster book value for these companies. These policies are about to be reversed, and mortgage REITs like Annaly Capital (NLY 1.69%) have seen their book values depressed ahead of the changes.
The Federal Reserve moves from tailwind to headwind
The Federal Reserve has signaled that it is about to start reducing the size of its balance sheet, and it will lean toward selling mortgage-backed securities in order to accomplish that. Annaly Capital is one of the big buyers of agency (in other words, government-guaranteed) mortgage-backed securities, which are similar to the Fed's holdings.
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The Fed's plan in the past has been to let its bond holdings mature, which will gradually work down the balance over time. This time around, the Fed may choose to sell some of its holdings into the market. The first option would be better for the mortgage REITs in that no additional selling pressure will be added to the market. The uncertainty over the Fed's plans weighed on mortgage-backed security valuations in the first quarter of 2022, and Annaly's holdings of agency mortgage-backed securities fell in price pretty dramatically.
Annaly's book value per share declined 15%
As of March 31, Annaly Capital reported that book value fell to $6.77 per share from $7.97 at the end of 2021. This is a 15% decrease, which is a lot for a mortgage REIT's book value to move in one quarter. The decrease in book value per share was due primarily to mortgage-backed securities underperforming Treasuries.
Annaly CEO David Finkelstein said in the press release that the environment was "one of the most challenging for fixed-income in decades." Not only did rates rise, but volatility of rates (in other words, how fast and far they move) also increased. Volatility is bad for mortgage-backed securities as well, so Annaly suffered a double whammy.
Mortgage servicing rights helped offset some of the losses
On the plus side, the decline in mortgage-backed securities was offset by the company's holdings of mortgage servicing rights, which is an esoteric asset that increases in value as rates rise. A mortgage servicer handles the administrative tasks of a mortgage -- things like collecting the monthly payments, making sure property taxes are paid, and dealing with delinquent borrowers.
The servicer is paid a fee of 0.25% (or one-quarter of one percent) of the outstanding balance on the loan. When rates rise, borrowers are unlikely to refinance, so the servicer can expect to collect that fee for a longer period. Mortgage servicing assets are extremely popular right now, and valuations are high.
It is hard to like the mortgage REITs in this environment simply because the Fed is such a threat to them. That said, the entire sector has been under pressure for a year, and Annaly has fallen 28% since May 2021.
The dividend is covered ... for now
Annaly said that earnings available for distribution came in at $0.28 per share, which means the $0.22 dividend is covered. At current levels, it gives the stock a yield of nearly 14%, which is hard to beat in this interest rate environment. The fact that the dividend remains well-covered should give investors some measure of comfort. For intrepid income investors, Annaly might be worth a look, but it will be subject to volatility courtesy of the Fed and economic data.
