The past year was downright awful for the mortgage space. Mortgage originators reported a collapse in origination volumes while mortgage real estate investment trusts (REITs) struggled with mortgage underperformance.
Now that interest rates seem to be falling, investors are taking a fresh look at mortgage REITs. Is Annaly Capital (NLY -0.32%) a buy at these levels?
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Mortgage REITs are different than the typical REIT
Annaly Capital is a mortgage REIT that invests in mortgage-backed securities (MBS) that are guaranteed by the government, mortgage loans that are not guaranteed, and mortgage servicing rights. Annaly's strategy is designed to work in all interest rate environments.
A mortgage REIT is different from the typical REIT. Most REITs develop properties such as apartments, office buildings, or shopping malls. They use a lot of debt to fund development and then rent out the individual units. The difference is their gross profit.
Mortgage REITs don't invest in properties, they invest in real estate debt. They borrow money, use the proceeds to buy MBS, and collect interest. The difference between the interest they earn and the interest they pay is their gross profit.
Mortgages underperformed Treasuries most of last year
Over the past year, MBS underperformed Treasuries. In trader parlance, MBS spreads have widened. The chart below shows the difference between the 30-year mortgage rate and the 10-year bond yield. The higher the number, the worse it is for mortgage REITs. In late 2022, the difference was the biggest in a number of decades. This was the big driver of the big declines in book value per share for the entire sector this year.
Fundamental chart data by YCharts.
Here is why underperformance is so bad. Mortgage REITs hedge against interest-rate risk using interest-rate derivatives. When rates rise, the value of Annaly's MBS portfolio falls, and the earnings from the interest-rate hedges are insufficient to offset the money lost on the MBS portfolio. This causes declines in book value per share.
Rising short-term rates are a headwind
The other headwind for mortgage REITs is rising short-term interest rates. Mortgage REITs tend to borrow short and lend long, which means their cost of borrowing and the amount they earn on the portfolio might diverge. As the Fed hikes short-term rates, Annaly's cost of borrowing is increasing, and there is no guarantee that the interest earned on the portfolio will keep up. This phenomenon is generally called narrowing interest margins, and it is a problem for almost all financials, not just mortgage REITs.
Annaly also invests in non-guaranteed loans, which have higher interest rates, and mortgage servicing rights, which increase in value as interest rates rise. This helps offset some of the issues with narrowing interest margins. On the other hand, if we enter a recession, the non-guaranteed mortgages will experience higher delinquencies, and Annaly's cost of servicing will increase.
The mortgage REIT sector has been cutting dividends
The big question for Annaly is the dividend. In the third quarter, Annaly lost $0.70 per share, but earnings available for distribution were $1.06 per share, which covered the $0.88 quarterly dividend. The difference is due to unrealized losses. The summer of 2022 was probably the worst for mortgage REITs as mortgage underperformance was peaking. It started reversing in the fourth quarter. If you look at the chart above, these fits of underperformance generally don't last long, so it is likely the worst is over.
While Annaly has not cut its dividend, many of its competitors in the mortgage REIT space have, including MFA Financial, Two Harbors Investment, and PennyMac Mortgage Investment Trust. Annaly has the highest dividend yield of the sector at 15.9%, and as a general rule mortgage REITs like to keep their dividend yields in the low single-digit percentages.
Given that MBS spreads improved over the past three months, perhaps the worst is over and Annaly won't cut its dividend, but nothing is guaranteed. Investors need to understand the risks of rising short-term rates and a potential recession before considering a purchase of this stock.
