Annaly Capital Management (NYSE:NLY) is set to report earnings on Wednesday, Feb. 24, and here are a three things to help get to the core of what the company is doing.  

 

1. Hedge ratio 
Over the last couple of years, the major concern for mortgage REITs, like Annaly, has been rising interest rates. This has become even more interesting recently as the Federal Reserve officially began increasing short-term rates this past December. 

One useful metric to judge how Annaly is managing rates is the "hedge ratio." Annaly's borrowings have floating interest rates, so when the Fed increases rates, it increases the company's cost of funds. To protect against this increase, Annaly uses things such as interest rate swaps to trade its floating rates for fixed rates and lock in borrowing costs. The hedge ratio is the percentage of its borrowings that are swapped for fixed rates. 

In general, the more concerned Annaly is about rising rates, the higher the hedge ratio. For instance, when the market believed that rates would inevitably skyrocket at the end of 2013, Annaly's hedge ratio was 92% -- but rates didn't rise. So, as of the third quarter of 2015, that figure has crept down to just 58%. 

Interest-rate swaps help protect borrowing costs, but they aren't cheap. For that reason, Annaly will only use as much as necessary. Based on the commentary earlier this month, Annaly's peers believe that rates will stay low. In fact, American Capital Agency's CIO, Gary Kain, stated that we should expect rates to stay "lower for longer." If Annaly is on the same page, then we could see its hedge ratio potentially crawl further down and Annaly's cost of funds improve. 

2. Net interest rate spread 
Lower cost of funds would be fantastic, but it is only half the equation. The other half is the yield Annaly earns on its investments. And when you combined the two you get the "net interest rate spread" -- or, the difference between what it costs Annaly to borrow, and the yield on its assets. 

In general, the larger Annaly's spread, the better its earnings and the larger its dividend. For instance, when Annaly's dividend was near its lowest in history in 2006, the company's spread was 0.49%. Over the next three years, Annaly's spread would widen out to 2.52% at the end of 2009, which produced the largest dividend per share in company history. Since then, Annaly's spread has narrowed and its dividend has been cut in half. 

During the third quarter of last year, Annaly's spread was 0.76%, or a normalized figure of 1.21%. For comparison, American Capital Agency's spread was 1.14% during the third quarter. Due to improvements in both its cost of funds and yield on assets, the company's spread jumped to 1.47% in the fourth quarter, and Annaly investors should hope for a similar progression. However, if Annaly's spread continues to tighten it will become more difficult to generate income, and potentially force future dividend cuts. 

3. Credit investments 
One of the ways Annaly has been attempting to widen its spread and open up new opportunities is by making credit investments. 

Like American Capital Agency, Annaly has historically invested in agency residential mortgage-backed securities -- or pools of housing debt packed into fixed-income securities. The benefit of these investments is that Fannie Mae and Freddie Mac guarantees them against default. However, over the past few years, Annaly has separated from its peers and started diversifying into credit investments, which includes different types of residential debt, as well as commercial debt and equity. All of these new investments carry the risk of default, but they also come with a higher yield.  

At the end of the third quarter, credit investments accounted for 18% of Annaly's stockholders' equity. Over the past few quarters, Annaly has been boasting about the wide range of opportunities that come with its new investment approach, suggesting that it will continue to increase the percentage of credit investment over time. 

Bonus: buybacks 
Ultimately, the goal is not to take quarterly earnings too seriously, but to keep track of how the company is doing, what direction it's taking, and any major changes in strategy it may be undergoing. 

With that in mind, If I can leave you with one final thought, it would be to look for commentary about repurchasing stock. According to an investor presentation Annaly released in early February, the company repurchased $207.2 million worth of stock during the fourth quarter -- approximately 2% of outstanding shares. Unlike many of its peers, which have been buying back stock consistently since late 2013, Annaly has avoided buybacks until now, and I'm curious to see why it decided that now was a good time to pull the trigger. 

 

Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.