Annaly Capital is the biggest U.S. mortgage REIT by market capitalization
Annaly Capital (NLY) is a self-managed REIT that invests in a variety of real estate–related securities, including pass-through certificates, collateralized mortgage obligations, callable agency debt, and other mortgage-backed securities (MBS). Recently, Annaly has focused on the agency product, and 90% of its portfolio has been dedicated to Fannie Mae, Freddie Mac, and Ginnie Mae mortgage-backed securities. However, Annaly’s charter gives it the freedom to allocate up to 25% of its portfolio in non-agency product. The company also invests in various agency-backed structured products such as floaters and inverse floaters, which provide tailored interest rate exposure.
The use of leverage
Mortgage REITs tend to have high dividend yields, yet agency mortgage-backed securities don’t pay low-double-digit returns. To achieve these sorts of returns, REITs—particularly agency REITs—employ leverage. In other words, they’ll borrow many times their equity in order to provide these high sorts of returns. The use of leverage is a double-edged sword. Even though agency mortgage-backed securities bear no credit risk (since principal and interest payments are guaranteed by the government), they do have a lot of interest rate risk, and leverage magnifies this risk.
When the Fed hinted at tapering at the June 2013 FOMC meeting, rates began to rise and REITs were clobbered. The hardest-hit were agency REITs. Since agency REITs invest in MBS (mortgage-backed securities) with no credit risk, the nominal returns are quite low. To generate a decent return, they employ a lot of leverage and were caught once rates started going up. They were forced to de-leverage in a difficult interest rate environment. In fact, Annaly cut its leverage ratio from 6.5x to 5x. While there are other risks that agency REITs face (like funding risk or counterparty risk), their biggest is interest rate risk.
The best comparable for Annaly is American Capital Agency (AGNC), which is also an agency REIT with a lot of exposure to fixed-rate agency MBS. Some REITs, like MFA Financial (MFA) or Capstead (CMO), invest primarily in agency adjustable-rate mortgages. Finally, non-agency REITs like Redwood Trust (RWT) invest in non-guaranteed MBS, so they bear credit risk.