The past year has been awful for investors looking at stocks having almost anything to do with housing. Homebuilders struggled with rising costs and mortgage rates, mortgage originators have seen a collapse in origination volume, and mortgage real estate investment trusts (REITs) have seen book values decline as rates rise. If you believe the futures index on the direction of the Federal Funds Rate, the Federal Reserve's tightening campaign is in the late innings, and we might be at the point of maximum pain for the sector.
As a result of all this, Annaly Capital Management (NLY 0.70%) stock was beaten up along with the rest of the mortgage REIT sector, and now sports a whopping 16.4% dividend yield. Is that yield real, and more importantly, is it sustainable?
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Mortgage REITs are different than the typical REIT
Annaly Capital is a mortgage REIT that holds a variety of assets. Mortgage REITs are a different animal than the typical REIT. Most REITs build shopping malls, or office buildings, or apartments, and then lease out the units; it's an easy-to-understand landlord-tenant model. Mortgage REITs don't buy property, though; they buy real estate debt (or mortgages). In this way, they more closely resemble a bank or hedge fund.
Annaly's investment portfolio consists primarily of mortgage-backed securities which are guaranteed by the U.S. government -- if the borrower doesn't pay, the government ensures the bondholders get paid.
Annaly also invests in mortgage servicing rights, one of the few assets that increase in value as interest rates rise. Mortgage servicers handle the administrative tasks of a mortgage on behalf of bondholders. They collect the monthly payments, they ensure taxes and insurance are paid, and they deal with the borrower in the event of a delinquency. In exchange, the servicer is paid 0.25% of the mortgage amount per year. The right to perform that service is worth something, and mortgage servicing rights can be traded.
The Fed's tightening regime has caused mortgages to underperform
All year, mortgage-backed securities have been under pressure as the Fed raised interest rates. Mortgage-backed securities underperformed Treasuries, which means they've fallen in value faster than an equivalent Treasury bond. Annaly's book value per share fell by 37.4% this year. This underperformance has an upside, however: It makes future expected returns on Annaly's portfolio of mortgage-backed securities higher.
Investors who buy Annaly based on the dividend yield are making the bet that the worst is over and that the underperformance of mortgage-backed securities will reverse as the Fed winds up its tightening regime. Earnings available for distribution are expected to equal the third-quarter dividend, so Annaly has little breathing room if the mortgage-backed securities market remains inhospitable.
The worst may be over, but wait for clarity
October's consumer price index came in better than expected, showing that inflationary pressures were easing; this caused Annaly to rally about 10% on the day. At current levels, Annaly is trading at about a 10% premium to book value, and as a general rule mortgage REITs rarely get too far above or below book value.
While investors may be tempted to chase Annaly, I think the time to buy is when the Fed signals that the tightening cycle is wrapping up. We'll get clarity on that after the December Federal Open Market Committee (FOMC) meeting when we'll get a fresh dot plot and economic projections.
Until then, the 16.4% dividend yield raises the chance of a dividend cut, and another indication that inflation is accelerating could be the catalyst for a cut. Tread carefully with this stock right now.
