When it comes to high-yield stocks, few companies offer higher income than mortgage REITs such as Annaly Capital Management (NLY).

However, it’s vitally important for dividend investors to realize that this industry is one of the hardest to consistently profit from, for numerous reasons.

Let’s take a closer look at Annaly Capital, one of the most popular mREITs, to see if this high dividend stock should be considered by those who need secure and dependable dividend income, such as retirees.

Business Description

Founded in 1997 in New York City, Annaly Capital Management is the by far the largest and oldest mREIT in America with over $12 billion in assets, which it primarily invests in residential mortgages that are guaranteed by Fannie Mae and Freddie Mac.

Like all mREITs, Annaly’s business model involves borrowing at short-term (lower) interest rates, in order to fund the purchase of longer-term higher-yielding assets, mostly residential and commercial mortgage-backed securities (MBS).

The difference between these rates is the net interest margin, or “spread,” which Annaly pockets.

Combined with a high amount of leverage (6.4:1 as of the end of 2016), this strategy creates around a 10% levered return that generates the company’s profits.

Annaly Capital Management

Source: Annaly Capital Investor Presentation

Annaly Capital Management

Since REITs must payout 90% of taxable income as unqualified dividends in order to avoid paying taxes, mREITs have some of the highest dividend yields you can find on Wall Street.

However, while Annaly’s high yield of 10.6% might initially seem appealing, investors need to remember that in this age of record low interest rates, such generous yields don’t come without a large amount of risk in most cases.

In fact, the risks facing Annaly are significant enough that most conservative dividend investors are likely better off steering clear of the industry entirely.

Business Analysis

As you can see, Annaly’s financial results are very volatile. That’s because mREITs’ highly complex business model is one of the most interest rate sensitive in the entire U.S. economy.

Annaly Capital Management

Annaly Capital Management

Source: Simply Safe Dividends

One reason for the volatility is that Annaly’s net interest margin spread isn’t the only thing that determines how much money the company makes. There are a handful of other risks to consider with mortgage REITs.

Annaly Capital Management

Since Annaly is required to pay out almost all of its profits as dividends, it is reliant almost exclusively on accessing external capital markets, meaning debt and equity, to run its business.

Most of the company’s debt funding is from the “repo,” or repurchase market. That means that Annaly will temporarily sell some of its MBS to raise capital to buy others, with the promise of repurchasing them later for a higher price (the interest rate).

The repo market is tied to the London Interbank Offered Rate (LIBOR), which is itself tied to numerous central bank interest rates, including the Fed funds rate which is now rising.

As a result, when U.S. interest rates rise, Annaly’s funding costs rise with them.

However, because the majority of residential mortgage loans are fixed-rate, the interest they pay Annaly doesn’t change, eliminating any benefits Annaly could have from rising interest rates in the short term.

Long-term mortgage rates will eventually rise as well in this environment, increasing Annaly’s loan yields, but it takes time.

However, the problem for Annaly is that, because of the low yields on mortgages, especially those insured by the government (so-called agency MBS), the company needs to use a large amount of leverage in order to generate the kind of profits that allow it to keep paying its fat dividend.

The company’s high leverage, while beneficial at times, is a double-edged sword when it comes to rising interest rates. Remember that like bonds, the value of Annaly’s MBS portfolio will move in the opposite direction of interest rates.

That’s because higher rates mean that older MBS need to sell at a discount in order for their effective yields to compete with newer, higher-yielding mortgage-backed loans.

As a result, Annaly’s book value, or net asset value (i.e. the fund’s value), will decrease as rates rise.

In fact, a 0.75% increase in interest rates is expected to reduce Annaly’s net asset value (NAV) by 11.8%:

Annaly Capital Management

Since mREIT shares generally trade in line with their book value, higher interest rates will likely cause a decrease in the value of an mREIT and thus put downward pressure on Annaly’s shares.

That’s potentially a problem because in addition to using a lot of leverage, an mREIT like Annaly is frequently raising equity capital (i.e. selling new shares).

You can see that Annaly’s diluted shares outstanding have about doubled since 2008, for example:

Annaly Capital Management

Raising equity capital is done to fund new investment opportunities, as well as acquire other mREITs, such as Annaly’s $1.5 billion purchase of Hatteras Financial in 2016, which gave Annaly more exposure to investments that benefit from higher rates.

In other words, in order to grow, mREITs are constantly fighting a battle with shareholder dilution, which makes securing, much less growing, the dividend very challenging at times.

That’s especially true if an mREIT’s share price declines due to rising interest rates and falling book value, potentially resulting in a dividend yield that climbs higher than an mREIT’s leveraged returns.

If the dividend yield on an mREIT’s stock exceeds the return it can earn by making new investments (e.g. shares yield 12%, but the company’s projects only earn a 10% return), it is not economical to issue equity for growth.

Another problem that investors need to know is that Annaly’s management team, which is one of the most experienced in the industry, constantly needs to evolve the firms’ business model.

Annaly’s management is diversifying away from agency MBS and into other businesses, such as commercial MBS and middle market lending (i.e. slowly turning itself into a Business Development Corporation, or BDC).

Why does Annaly want to go that route? Two main reasons.

First, a more diversified business model means more stable cash flow (and dividends) over time.

For example, falling interest rates can result in losses for pure-play residential mREITs because they generally buy their MBS portfolios at a 5% to 10% premium and count on long-term cash flow from mortgage payments to amortize that premium.

In a falling interest rate environment, however, mortgage refinancing can lead to prepayments and permanent capital losses for mREITs.

Commercial MBS, on the other hand, don’t face nearly as much prepayment risk.

Better yet, most commercial MBS are adjustable rate loans, with their interest rates tied to LIBOR.

In other words, commercial mREITs actually benefit from rising interest rates because they borrow at fixed rates, but their loan portfolio yields (and thus their net interest margin spreads) rise with higher interest rates.

The same is true for BDCs, which make loans to subprime businesses, often at interest rates of 12% to 14% that are generally tied to LIBOR as well.

So Annaly’s pivot away from a pure-play residential mREIT business model could be a great long-term strategy.

However, it’s also one that is fraught with risks and challenges that the company will have to face in the coming years.

Key Risks

The mREIT industry is one with many risks, even for the largest and best capitalized mREIT such as Annaly.

Unlike equity REITs, which own rental properties, Annaly, like most mREITs, doesn’t own any tangible assets.

These businesses are nothing more than publicly traded investment funds. That means that they can, and frequently do, lose money, making for extremely high dividend and share price volatility.

While it’s true that Annaly has generated very impressive total returns since its IPO, you need to remember that this only applies to investors that held on for the entire 20-year period and reinvested all the dividends (such as through a Dividend Reinvestment Plan, or DRIP).

Annaly Capital Management

However, over those decades, Annaly’s dividend has fluctuated wildly. In fact, the company’s current dividend is 55% smaller than it was in 2010 and is less than the total amount Annaly paid out in 1998.

Annaly Capital Management

In addition to the prospects of falling income, investors in Annaly have faced steep share price declines as well, including:

  • 2005: -44%
  • 2008: -47%
  • 2012 to 2016: -54%

In other words, while Annaly Capital’s 20-year total returns show that one could have generated great returns from mREITs over the last two decades, owning such a stock requires an almost superhuman dedication to long-term buy and hold investing and dividend reinvestment – one that very few people have.

Most importantly, just because Annaly has been able to generate great returns since its 1997 IPO doesn’t mean that investors (even those with the discipline to hold such a volatile stock) should expect similar results going forward.

That’s because most of Annaly’s success has occurred during a major rally in bonds, one that began in 1982 when 10-year Treasury yields peaked at 16% and lasted 35 years until rates bottomed at 1.36%.

Annaly Capital Management

Source: Federal Reserve Bank of St. Louis

With interest rates and borrowing costs now rising, and long-term rates rising more slowly (which compresses the net interest margin spread), Annaly may be in for years of declining profitability if this trend continues.

That’s especially true because the last time interest rates were rising, Annaly benefited from the housing bubble’s crazy preference for adjustable rate mortgages, or ARMS, whose yields rise with rates.

Annaly’s loan portfolio was 65% adjustable rate mortgages during the last rising interest rate cycle, while only 13% of the company’s portfolio is in such loans today.

Annaly Capital Management

Even factoring in the company’s new commercial MBS and BDC business segments, only 25% of Annaly’s portfolio will benefit from rising rates.

In other words, Annaly isn’t nearly as well positioned to offset the losses in book value and handle the spread compression from rising interest rates that could result in falling cash flow and dividends.

Annaly Capital’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

Annaly Capital Management

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

Annaly Capital has a Dividend Safety Score of 15, indicating that the company’s dividend is less reliable and at greater risk of being cut over a full economic cycle.

The company’s weak score is not surprising given that the mREIT industry is characterized by variable and volatile dividends. As we saw earlier, Annaly’s dividend has fluctuated significantly since the company went public.

Annaly Capital Management

That volatility is easy to understand when you consider how Annaly’s boom and bust earnings make for chaotic and unsustainable payout ratios at times.

Annaly Capital Management

The substantial financial leverage used by Annaly to boost its portfolio’s returns adds more risk to the company’s cash flows and dividend, especially given the company’s high payout ratio.

Essentially, anyone willing to own Annaly Capital, or almost any mREIT for that matter, can’t depend on secure and stable dividends from these high-risk investments (especially if interest rate rise, in the case of Annaly).

Annaly Capital’s Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Annaly Capital has a Dividend Growth Score of 1, indicating that investors shouldn’t expect much dividend growth anytime soon.

That should come as no surprise based on the company’s history of massive increases and decreases in dividends over the years, resulting in 7.7% annual dividend growth over the last decade but annual dividend decay of 13.2% per year over the last five years.

Annaly Capital Management

With the Federal Reserve expecting interest rates to rise by 2.25% in the next few years, Annaly could face significant challenges, such as ever greater spread compression that analysts expect will result in mid-single-digit declines in annual earnings growth over the next few years.

With the company’s payout ratio already so high, this is likely to force the company to reduce its payout by similar amounts. Annaly’s quarterly dividend amount has been frozen since 2013 and remains fragile.

Valuation

Given the risky nature of Annaly Capital, even the most risk tolerant investors should only ever consider buying shares when they are trading at a significant discount to their historic norms.

For mREITs, this means looking at the Price-to-Book Value ratio (P/BV) and dividend yield, relative to their long-term historical median levels.

mREIT P/B Ratio Historical P/BV Ratio Dividend Yield Historical Yield
Annaly Capital Management 1.02 1.04 10.6% 12.5%
Industry Median 1.13 NA 5.2% NA

Source: Gurufocus

As you can see, from a P/BV perspective, Annaly’s current valuation is within its historical range.

However, the yield is lower than what NLY’s stock has historically offered, which means that investors today don’t seem to be very well compensated for the risk of future dividend cut.

Closing Thoughts on Annaly Capital Management

Mortgage REITs such as Annaly Capital Management might offer the allure of sky-high dividends, but investors need to realize that these yields are often not safe and can certainly decline in a rising interest rate environment.

While a small number of high risk, extremely disciplined investors might be able to profit from this industry, most dividend seekers are likely better off avoiding mREITs.

Instead, they can focus on some of the best high dividend stocks for safe income (see 28 high dividend stock ideas here). While the yields on these investments may be somewhat lower, they are far safer, offering secure and steadily growing income that is more likely to help you meet your long-term financial goals.

Article by Simply Safe Dividends