NLY Chart

What
Shares of Annaly Capital Management (NYSE:NLY), a mortgage real estate investment trust that purchases agency mortgage-backed securities (securities protected from default by the U.S. government), were clobbered in June, per S&P Capital IQ, to the tune of 9% (inclusive of the dividend payout) on the heels of rapidly rising Treasury yields and subsequent commentary from the Federal Reserve.

So what
One of the biggest factors weighing on the entire mREIT sector is the June Federal Open Market Committee meeting, which basically signaled that the governing body was on track for a federal funds target rate hike in September. An improving U.S. economy, complete with a falling unemployment rate, is sending all the right signals for the Fed to take action. Unfortunately, mREITs thrive when rates are falling and find their net interest margin pressured when rates are rising. Long story short, profits for Annaly and the sector are expected to dip as lending rates normalize in the coming years.

The more immediate problem was the markets' likely reaction in expectation of that September move from the FOMC. In June the yields on short-term and long-term Treasuries rose notably, with the two-year Treasury yield rising from 0.61% to as high as 0.75% as the 10-year jumped 39 basis points to nearly 2.5% at one point.

Images
Source: Pictures of Money via Flickr.

Now what
Rising rates are a big concern for agency-backed mREITs like Annaly because of the amount of leverage these companies employ.

As of its most recent quarter, Annaly's economic leverage totaled 5.7-to-1. When interest rates are falling, or even steady, Annaly can use this leverage to really pack on the profits and juice up its double-digit dividend yield for its shareholders. However, when yields begin rising, the inverse relationship between the fixed-income assets (e.g., mortgage-backed securities) in its portfolio and lending rates should mean an amplified decline in the net asset value of Annaly's asset portfolio.

If there are some positives here for investors, it's that Annaly has been diversifying its assets and scaling back on its leverage to be more prepared for the expected change in the federal funds rate. Further, even in a rising-rate environment, Annaly has historically trounced the dividend yield of the broader market. This should lend hope to long-term investors that staying the course could still result in substantial gains.

So what's an investor to do? If you have that long-term view in mind, then picking up shares here might not be a bad idea. Yes, Annaly's margins, net asset value for its portfolio, and dividend are all likely to fall, but that's pretty much implied, given that the company trades well below its common-stock book value of $12.88 as of the end of the first quarter. If, however, you're just chasing Annaly's high-yield dividend with a shorter investment horizon, you'll probably be sorely disappointed.

Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

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