The past 15 months have been particularly tough for the mortgage real estate investment trust (REIT) industry. Mortgage-backed securities (MBS), pools of mortgages that when combined look and perform much like a bond, were put under pressure as the Fed raised rates. They were further damaged by Silicon Valley Bank's failure, caused in part by losses on MBSs. Annaly Capital (NLY 0.59%) is one of the top mortgage REITs, with a large yield. Is it a buy?
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Annaly Capital has three basic strategies
Annaly Capital Management is one of the biggest mortgage REITs out there. Unlike other REITs, which own properties and collect rents, mortgage REITs use borrowed money to buy investment securities related to real estate and collect interest.
The biggest part of Annaly's investment portfolio goes to agency MBSs that are guaranteed by the U.S. government. If you recently bought a house with a mortgage guaranteed by Fannie Mae or Freddie Mac, chances are it ended up in a MBS, which could be held by a mortgage REIT like Annaly. These securities have no credit risk, which means that even if the borrower doesn't pay the mortgage, the U.S. government ensures that Annaly still gets the principal and interest it is owed. That said, as we saw with Silicon Valley Bank, these securities can still fall in value if the interest rate risk isn't hedged.
The second strategy for Annaly is residential credit, and this involves mortgage loans that are not backed by the U.S. government. These include reperforming loans in which the borrower stopped paying, but then resumed payments; nonqualified mortgages not eligible for a government guarantee; land loans to professional real estate investors; and credit risk transfer securities.
The final strategy is mortgage servicing rights, which are an unusual asset. The mortgage servicer administers the loan on behalf of the investor. The servicer sends out the monthly bills, collects the payments, forwards the funds to the investor, ensures property taxes are paid, and works with the borrower in the event of default. The servicer is paid 0.25% of the principal amount outstanding of the loan as compensation. The right to perform this service is worth something, and it is capitalized on Annaly's balance sheet as an asset.
MBS have underperformed Treasuries
Last year, MBSs underperformed Treasuries by a lot. This drove down Annaly's book value and caused the company to cut its dividend. That said, mortgage servicing rights performed well, because they're one of the few assets that increase in value as interest rates rise.
Unlike Silicon Valley Bank, Annaly does hedge its interest rate risk, but the gains from the hedges have been insufficient to make up for the losses on the MBS portfolio. This drove the decline in book value per share from $31.88 at the end of 2021 to $20.77 at the end of March 2023.
The investment case for Annaly Capital depends on two big factors. The most important is MBS underperformance. The chart below shows the difference between the 30-year mortgage and the 10-year Treasury, now the widest since the late 1980s. The higher the number, the worse MBS are performing relative to Treasuries. The underperformance has been largely due to the Fed's increase in interest rates, although it appears that the Fed is close to wrapping that up.
Data source: YCharts
The second major theme is mortgage delinquencies, which are less important than MBS spreads. Increasing mortgage delinquencies hurt mortgage servicing rights and the values of nonguaranteed mortgage products. As the Fed's tightening starts to weaken the labor market, and as student loan repayments resume, we should see a return to normal levels of in delinquencies, which are at their lowest rate in 17 years.
Annaly recently cut its dividend, so another cut is probably not in the cards unless things get materially worse. MBS spreads do seem mean-reverting, which means the current pain in the MBS market probably won't last. If MBS spreads narrow, and delinquencies don't get too out of hand, then the dividend is probably safe. Annaly now has a dividend yield of 13%, which is attractive compared to most other income stocks. I think investors who are interested in Annaly should wait until the Fed signals it is done hiking rates, and once the uncertainty about monetary policy is removed, MBS spreads should narrow. Then Annaly will be a buy.
