If you are looking for passive income from your portfolio, Annaly Kapitaal (NYSE: NLY) and the 13% dividend yield is probably a stock you’ve seen before.
The mortgage real estate investment trust (mREIT) allows investors to invest in the U.S. housing market and could be a way to capitalize on the higher mortgage rates in the current climate. However, the stock is highly sensitive to interest rates, which have weighed on the company in recent years. If you’re considering buying Annaly Capital for its high dividend yield, consider the following first.
How Annaly Makes Money
Annaly invests in mortgage-backed securities (MBS), pools of residential mortgage loans that are bundled and sold to investors. Government-sponsored entities, such as the Federal National Mortgage Association (Fannie Mae) and the Federal Mortgage Mortgage Corporation (Freddie Mac) guarantee the repayment of principal and interest on these mortgage investments, which can limit risk to some extent.
However, the company competes in a commodity-like business, competing for the same MBS as competitors, making it difficult to stand out. And because its mortgage yields aren’t high enough in relative terms, the mREIT uses leverage to increase the return on its portfolio.
Annaly uses repurchase agreements (repo) and other financial instruments to enhance and magnify returns. The company aims for an economic leverage ratio of less than 10:1, the ratio of its debt and derivatives divided by its total equity.
By using capital and borrowed funds to invest in MBS, Annaly can earn the spread between the return on its assets and the cost of its borrowings. Because it borrows short-term while investing long-term in MBS, it is sensitive to changes in the yield curve, which represents the relationship between interest rates and the time until an asset matures.
Interest rates have risen across the yield curve in recent years. Last year, Annaly’s average yield on its interest-bearing assets was 4.33%, reflecting its investments in the higher mortgage rate environment. However, its average cost of liabilities was 3.01%, up from 0.79% two years earlier. As a result, the net interest rate spread narrowed to 1.89% in 2021, from 1.32%.
Another way Annaly feels the impact of higher interest rates is in the book value of its portfolio. The book value of debt-related securities is sensitive to changes in interest rates. When interest rates rise, the value of those securities falls. Over the past two years, Annaly’s book value per share has fallen 39%.
Disappointing returns for investors
Annaly’s sensitivity to interest rates makes it vulnerable to changes in economic and market cycles. In recent years, the stock has not given investors what they were looking for. Since 2018, Annaly’s total return (including the effect of dividend reinvestment) is -5.6%. So despite investors “earning” a double-digit dividend yield, the stock has fallen by 58%, making the net return negative.
Longer-term structural factors could lead to higher interest rates compared to the decade before the pandemic.
For example, JPMorgan Chase CEO Jamie Dimon warned that widening budget deficits, a restructuring of global trade, mounting government liabilities and geopolitical uncertainty could make this decade more volatile than the last. For this reason, higher interest rates make Annaly less attractive to me as a long-term (five years or more) investment.
Is Annaly the right person for you?
That said, I think Annaly could do well if the Federal Reserve starts cutting interest rates. According to CME GroupMarket participants are pricing in as many as six rate cuts of 0.25% over the next year, according to the bank’s FedWatch tool.
Annaly, which has increased its portfolio returns, would benefit from falling interest rates, which could help reduce its short-term financing costs. Falling interest rates would also boost its book value after several years of declines.
While it could do well over the next year or so if rates start to come down, structural factors could keep rates high for the next decade. Given Annaly’s sensitivity to interest rates, use of leverage, and lack of a robust competitive advantage, I’d rather look elsewhere for yield.
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JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. Courtney Carlsen has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends JPMorgan Chase. The Motley Fool has a disclosure policy.
Annaly Capital: Buy, Sell or Hold? was originally published by The Motley Fool
