This year has been extraordinarily difficult for mortgage companies. Mortgage banking companies have experienced huge declines in revenue and profits, and many major players have shut down. Mortgage real estate investment trusts (REITs) have dealt with an unprecedented increase in interest rates during a short period of time. How is Annaly Capital (NLY 0.25%) faring? 

The Federal Reserve building.

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Annaly Capital is exposed to credit risk and interest rate risk

Annaly Capital is a mortgage REIT that owns a portfolio of agency mortgage-backed securities that are guaranteed by the U.S. government, as well as loans that are not guaranteed. This means that Annaly's portfolio contains both credit risk and interest rate risk. Agency mortgage-backed securities generally pay low rates because of government guarantees, but they contain no default risk. Mortgage REITs need to use a lot of leverage (in other words, borrowed money) to turn a portfolio of loans paying 4% into a double-digit dividend yield. 

Annaly also holds non-guaranteed loans that are generally referred to as "non-QM," which stands for non-qualified mortgage. These loans are not eligible for sale to government-sponsored entities or to the government. These loans are often made to professional real estate investors who intend to use rental income to pay the mortgage.

These loans have nothing in common with the subprime, no-money-down loans from the bad old days. The borrower generally has to put down 30% of the purchase price and show that rental income will be sufficient to pay off the loan. Annaly is building out its non-QM business, and intends for it to be a larger percentage of its assets in the future. This means that Annaly's mix of credit risk and interest rate risk will change as well. This will make the company more susceptible to the overall economy instead of just interest rates.

Mortgage-backed securities are underperforming

During the past quarter, the difference in rates between the typical mortgage and the corresponding Treasury bond has increased. In trader parlance, mortgage-backed security spreads have widened, which tends to happen when financial markets are stressed. Even though mortgage REITs such as Annaly tend to hedge their interest rate risk, the value of their holdings fall when rates rise, and the gains from hedge positions have been insufficient to offset those losses. For this reason, Annaly's book value probably fell in the latest quarter. 

Why have mortgage-backed security spreads widened? There are two big drivers of this. The first is interest rate volatility. Mortgage-backed securities react negatively to big increases in interest rates, and this has been the case as the Federal Reserve raises rates to tamp down inflation. The second big reason has been fears that the Fed will dump its portfolio of mortgage-backed securities that it bought since the financial crisis to support the economy. The Fed owns about $2.7 trillion worth of mortgage-backed securities, and that potential supply has been a cloud over this market. 

Beware of huge dividend yields

As a general rule, mortgage REITs tend to have higher dividend yields than so-called equity REITs that own and lease out properties. A double-digit dividend yield is not necessarily a warning sign for a dividend cut, as it would be for many other companies. But investors should always ask if a dividend yield is too good to be true, because it often is and it may be telling you that a dividend decrease is coming. At current levels, Annaly is trading with a dividend yield of almost 20%. 

NLY Dividend Yield Chart

NLY Dividend Yield data by YCharts

The last time Annaly's dividend topped 20% (in early 2020), it ended up cutting it soon thereafter. Annaly just did a reverse stock split, which is another warning sign for the market. 

When will Annaly become too cheap to ignore? My sense is that once the Fed signals that it is done hiking rates, the mortgage REIT sector will become investible again. This will remove some of the interest rate volatility from the market, which will be supportive of mortgage-backed security prices. Until then, investors should be careful with stocks like Annaly.