The mortgage real estate investment trust (mREIT) Annaly Capital Management (NLY 0.75%) currently has an eye-popping annual dividend yield that tops 17%. While the high yield may attract a lot of investors looking to generate passive income, usually, the rule of thumb in dividend investing is to be wary of high yields. Let's take a look at why Annaly has such a high yield.

Lower book value is the culprit here

The first thing to understand about Annaly is that, as a REIT, the company qualifies for special tax advantages. But to get those, Annaly must pay out at least 90% of its annual taxable income in dividends. This is why most REITs are known for having above-average dividend yields, although definitely not 17%.

MREITs, however, are different from REITs in that instead of investing in actual real estate, they invest in real estate bonds. Annaly largely invests in mortgage-backed securities (MBS) guaranteed by the government or agency MBS. While these bonds do not face a lot of credit risk, they do face interest rate risk. Bond values and yields have an inverse relationship, so as yields, rise bond values fall (and vice versa). As the Federal Reserve raised rates aggressively and mortgage rates soared, Annaly started to rack up unrealized losses, especially in its agency MBS portfolio.

While these are only losses on paper (unless Annaly had to sell bonds while they traded at a loss) and should be recouped as rates stabilize and bonds mature, they are marked to market each quarter and therefore impact book value. As book value has fallen, so have shares of Annaly, which has increased the dividend yield.

NLY Book Value (Per Share) Chart

NLY Book Value (Per Share) data by YCharts

Furthermore, rising rates also pressured Annaly's earnings available for distribution (EAD) to shareholders, which is a key indicator of how well covered the dividend is. That's because Annaly's main source of earnings comes from the difference it makes on its interest-earning assets such as agency MBS and the interest it must pay on debt to fund these assets.

In recent quarters, Annaly's funding costs have started to rise significantly, and the rise in yields on its assets or revenue from its other smaller businesses has not been enough to offset it, leading to margin compression. In the fourth quarter of 2022, Annaly's net interest margin fell to 0.65% from 1.42% in the third quarter, although on an adjusted basis with hedging the decline wasn't nearly as bad.

Even more worrisome is that EAD in the fourth quarter fell to $0.89, which is just a penny more than the company's quarterly dividend. On the company's fourth-quarter earnings call, it announced plans to soon lower the dividend to around an 11% or 12% yield, which management believed would be more sustainable.

Big yields bring big risk

It will be interesting to see if the new dividend yield can hold up until conditions get better for Annaly. The big risk is that if inflation proves stickier than anticipated and the Fed needs to hike rates more than anticipated, perhaps to 6%.

That would not only once again increase pressure on Annaly's book value per share but also continue to weigh on earnings and make another dividend cut possible.