With their eye-popping dividend yields, mortgage real estate investment trusts (REITs) are attracting interest from income investors as many have double-digit dividend yields. The mortgage REIT sector has been battered over the past year as interest rates rose quickly and caused many to report big declines in book value per share and cut their dividends. Annaly Capital (NLY 1.02%) is one of the top mortgage REITs out there. Is the worst over for this high-yield stock and is it a buy?
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Annaly follows three investment strategies
Annaly Capital is a mortgage REIT that follows several strategies. Annaly's main strategies include agency, residential credit, and mortgage servicing. The agency strategy invests in mortgage-backed securities (MBS), which are guaranteed by the U.S. government. This is a classic mortgage REIT strategy.
Residential credit focuses on mortgages that are not guaranteed by the U.S. government. These are often made to professional real estate investors for fix-or-flip strategies, build-to-rent or construction loans. These loans carry higher rates than loans guaranteed by the U.S. government.
Mortgage servicing saved the day in 2022
Mortgage servicing is an unusual asset. The mortgage servicer handles the administrative duties of the mortgage on behalf of the mortgage investor. The servicer sends out the monthly statements, collects the payment, forwards the proceeds to the investor, ensures property taxes are paid, and works with the borrower in the event of default.
The servicer is paid one-quarter of one percent (0.25%) of the loan's outstanding balance as compensation. The right to perform this service is worth something and is capitalized on the balance sheet as an asset.
Each of Annaly's strategies is designed to outperform in different environments. During a rising interest rate environment, like we have experienced over the past 18 months, mortgage servicing shines. This is because the refinancing incentive disappears, and therefore, the servicer is expected to receive that 0.25% payment for longer.
During falling interest rate environments, the other strategies will outperform. Agency MBS increase in price as rates fall, and decreasing interest rates usually stimulate housing activity, which increases demand for residential credit.
The Fed has been a headwind for the entire sector
Ever since the Federal Reserve began hiking interest rates, mortgage REITs have been battered. While MBS are bonds that don't like rising rates, they also don't like volatility. Volatility has increased in the bond market, causing MBS to underperform Treasuries.
Mortgage REITs hedge their interest rate risk, but in this case, the gains on their hedge portfolio were insufficient to compensate for the losses on the investment portfolio. During 2022, Annaly's book value per share fell from $31.88 to $20.79.
While the Fed isn't finished hiking rates, as long as inflation continues to work its way lower, they look to be close to the end of this rate cycle. Uncertainty about the Fed will remove a big catalyst for bond market volatility, which should translate into MBS outperformance going forward. Falling rates won't necessarily be good for mortgage servicing, but steady rates shouldn't negatively impact servicing valuations.
Income investors concerned primarily about capital preservation might want to hold off on investing in the mortgage REIT space until the Fed gives the all-clear signal. That said, Annaly has cut its dividend already, so unless things deteriorate further, the dividend is probably safe for now. The stock yields 13.5% and is trading at a small discount to book value per share. The worst is in the rearview mirror for the mortgage REITs; however, cautious investors may want to wait for the Fed.
