Investors looking for yield are beginning to take a closer look at mortgage real estate investment trusts (REITs). Some of these stocks now have double-digit percentage dividend yields, which can help account for the elevated inflation being seen in the U.S. economy.
But mortgage REITs are not for the faint of heart.
Annaly Capital Management (NLY -0.54%) is one of the biggest mortgage REITs operating today and it is among those REITs with an elevated payout. Why does it have such a high dividend yield?
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Annaly Capital employs several different strategies
Annaly Capital is a mortgage REIT that invests in several different strategies. The company buys agency mortgage-backed securities, which are guaranteed by the U.S. government. If you recently bought a home with a mortgage backed by Fannie Mae or Freddie Mac, chances are it ended up in an agency mortgage-backed security. This strategy has historically been the bread and butter of mortgage REITs. The agency book is the largest portion of Annaly's investment portfolio.
Another piece of Annaly's portfolio is credit-sensitive strategies. Annaly Capital also originates mortgages that are not guaranteed by the U.S. government. These loans generally go to professional real estate investors with construction loans, fix-and-flip loans, and loans supported by rental income. These loans tend to have higher interest rates than agency loans, but they are riskier.
The third strategy is mortgage servicing rights, which are a popular asset these days. A mortgage servicer performs the administrative tasks of handling a mortgage on behalf of the ultimate investor. The servicer sends out the monthly bills, collects the payments, forwards the payment to the investor, ensures property taxes are paid, and works with the borrower in the event of default. The servicer gets paid 0.25% (or one-quarter of 1%) of the principal value of the loan for performing this service. On a $400,000 loan, the servicer is paid $1,000. The right to perform this service is worth something and it is capitalized on the balance sheet as an asset.
Mortgage servicing rights are unusual in that they respond positively to rising interest rates. Stocks and bonds generally fall in value when rates are rising. Mortgage servicing rights have helped a lot of mortgage originators and REITs keep the lights on over the past year as the Federal Reserve has been raising interest rates.
These three strategies use leverage (or borrowed money) to generate an expected return of 13% to 15%. Leverage is a double-edged sword. When the asset is making money, it accelerates the gains. When an asset is losing money, the reverse happens. That happened big-time in 2022.
Mortgage-backed securities have underperformed Treasuries
In 2022, agency mortgage-backed securities underperformed Treasuries, and this explained why every mortgage REIT reported declines in book value per share last year. You can see this in the chart below, which shows the difference in rate between the 30-year fixed-rate mortgage and the 10-year Treasury. The larger the number, the deeper the underperformance.
Fundamental Chart data by YCharts
Almost all were forced to cut their dividends. Annaly cut its quarterly dividend from $0.88 per share to $0.65 in March. As you can see from the chart above, the underperformance is at extremely high levels and these tend to not stay there long. Investors betting on Annaly are betting that mortgages will outperform Treasuries going forward. Part of the reason for the underperformance is uncertainty about what the Federal Reserve is planning to do with interest rates. Once the Fed indicates it is done raising interest rates, that will probably act as the catalyst for mortgages to outperform.
At current levels, Annaly has a dividend yield of 13.7%. This dividend is probably sustainable as long as mortgages don't continue to underperform. If the U.S. hits a recession that could help agency mortgages. However, Annaly risks delinquency issues on its credit portfolio. Overall, investors might be tempted by Annaly's dividend yield, but should probably wait for the all-clear signal from the Fed.
