Insights

Here’s Why Things Might Be Looking Up For Annaly Capital

Mortgage real estate investment trusts (REITs) have been put through the wringer since the beginning of COVID-19. First, they suffered through margin calls, then a refinancing wave, and now a hawkish Federal Reserve. That said, it looks like the storm clouds are parting, and things could be looking up for mortgage REITs like Annaly Capital Management (NYSE: NLY)

Image source: Getty Images.

Annaly invests in mortgage-backed securities, loans, and servicing assets

Annaly invests in agency mortgage-backed securities (MBS), which are guaranteed by the government. In other words, if we hit a recession and borrowers fail to make their mortgage payments, Annaly still gets its principal and interest. Annaly also invests in mortgages that do not conform to agency guidelines. These loans do not have a government guarantee, so if the borrower defaults, Annaly bears the losses. That said, these loans have higher rates than agency securities. Finally, Annaly invests in mortgage servicing rights. 

Mortgage servicing rights are an unusual asset. The mortgage servicer handles the administrative tasks of a mortgage, such as collecting payments, ensuring property taxes are paid, and handling defaults. For this service, they are paid 0.25% of the mortgage balance per year. The most interesting characteristic about mortgage servicing rights is that they tend to increase in value as rates rise. Most other assets such as stocks, bonds, and real estate are negatively affected by rising rates, which makes this somewhat unusual. These mortgage servicing rights actually end up providing Annaly with a natural hedge for its portfolio. 

The Federal Reserve is winding up its tightening cycle

So why does Annaly stock look interesting right now?

The big reason is that the Fed appears to be in the latter stages of the current cycle of tightening credit. If you look at the Fed Funds futures, you can get a market forecast for what rates will be. The December 2022 Fed Funds futures have the target rate of about 100 basis points (or 1%) higher than it currently is. Looking into next year, rates remain stable. This is good news for the company as anticipated rate hikes have been weighing on mortgage-backed securities in general and mortgage REITs in particular. 

In addition, mortgage origination has been slowing. Rising home prices and mortgage rates have negatively affected affordability. This is another positive (at least from a mortgage REIT’s perspective) because the Federal Reserve is no longer buying mortgage-backed securities to support the economy and is letting its portfolio mature. The exit of one of the biggest buyers of mortgage-backed securities has been another dark cloud over the market. The lack of mortgage origination means the market is more balanced. 

Lowered volatility means mortgage-backed securities should outperform Treasuries

Finally, volatility in the bond market is a negative for mortgage-backed securities. On the earnings conference call, Chief Investment Officer Ilker Ertas said that volatility in the MBS market was the highest since 2009 (except for a brief spike in the early days of the pandemic). As volatility subsides, mortgages should outperform Treasuries. 

Annaly is trading at a premium to its June 30 book value per share of $5.90, and I generally like to buy them at a discount to book. Annaly agrees and has taken the opportunity to issue approximately $665 million worth of stock. That said, the company sees economic earnings covering the $0.22 quarterly dividend for the foreseeable future. At current levels, the stock has a dividend yield of 12.8%, which is pretty attractive in this environment. If income investors can pick up this stock below book value, it could make sense to reenter the mortgage REIT space.  

Brent Nyitray, CFA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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