Annaly Capital Management portfolio yield continues to fall

AnnalyEnlarge GraphAnnaly Capital Management is a diversified mortgage REIT

Annaly Capital Management owns, manages, and finances a portfolio of real-estate related investments, which are generally backed by mortgages. While they have been primarily focused on agency (government-guaranteed) mortgages, they aren’t required to be in agency paper – their mandate is to invest 75% of the portfolio in high quality mortgages, which does not necessarily mean government-guaranteed.

Annaly is a Real Estate Investment Trust, which means that they do not pay tax at the corporate level, provided that they distribute 90% of their net income. This means they have high (and volatile) dividend yields. Over the last 12 months, Annaly’s dividend yield has been 12.3%.

Highlights of the quarter

Annaly reported net income of 47 cents a share before special items, beating the street estimate of 37 cents. Revenues fell 3% quarter-on-quarter and 20% year-over-year as rates have dropped. The average yield of the portfolio was 2.37%, and the average cost of funds was 1.46%, giving an average interest rate spread of 91 basis points. This was a drop of 80 basis points from a year ago. Leverage increased slightly to 6.6x from 6.5x at the end of 2012 and 5.8x a year ago.

Fixed rate agency mortgage backed securities constituted 92% of the portfolio. Adjustable rate agency MBS made up the balance. Overall, it looks like Annaly is sticking with an investment policy that mirrors what the Fed is doing through asset purchases (or quantitative easing).

Read-across to other mortgage REITs

Annaly’s portfolio risk is very different from MFA Financial’s (MFA), who also reported today. Annaly is highly levered and invests in agency fixed rate mortgages. This means they have much higher interest rate risk than a REIT like MFA which invests in 15 year mortgages and adjustable rate mortgages. If interest rates stay low for the next several years, Annaly’s bet will pay off. If interest rate spike up unexpectedly, then Annaly’s portfolio will suffer more than a REIT that focuses on adjustable-rate mortgages like MFA or Capstead (CMO). Similarly, they will face higher interest rate risk than a non-agency REIT like PennyMac (PMT). On the other hand, the non-agency REITs bear credit risk. If the economy turns down and real estate prices fall again, Annaly’s portfolio will outperform the non-agency REITs.

Annaly’s biggest risks are prepayment risk and interest rate risk. Given that they focus on fixed rate mortgages, they are at risk if the Fed continues to push down interest rates and triggers another refinancing wave. Annaly has the flexibility to change its portfolio and it may decide to take steps to reduce interest rate risk if it looks like the Fed is changing course. They can reduce leverage, shorten duration, or swap into adjustable-rate mortgages.