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

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