AAs the economy recovers from the disruption associated with COVID-19, investors are starting to pay much more attention to the Federal Reserve and how its actions will affect their portfolios. Nowhere is this more of a concern than in the mortgage confidence in real estate investment (FPI), where companies like Annaly Capital (NYSE: NLY) are positioning themselves for when the Fed begins to reduce its purchases of mortgage-backed securities. Annaly recently released her second quarter results and provided an update on how she is preparing for the end of the Fed’s asset purchases.
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Mortgage REITs have a different business model
Annaly Capital is a mortgage REIT, which is different from the more traditional REIT. Most REITs follow an owner / tenant model in which the REIT develops a property and then leases the units. Her profit margin is very roughly the difference between what she pays in interest and her rental income. Mortgage REITs do not invest in real estate; they invest in real estate debt (ie mortgages). Their profit margin is the difference between the interest they earn on their mortgage portfolio and what they pay in interest on their loans.
Annaly Capital invests primarily in mortgage backed securities that are guaranteed by the US government (aka agency securities). Most mortgage loans from the United States fall into this category. If you recently refinanced your mortgage, your loan was probably in a title similar to the ones Annaly holds. If you get into trouble and are unable to make your mortgage payments, Annaly will still receive the payments owed to her.
Fed fears weakening the value of Annaly’s portfolio
While these mortgage backed securities are government guaranteed, they are not without risk. In the last quarter, Annaly reported a 6.5% drop in book value per share, due to the underperformance of mortgage-backed securities. In the vernacular of the investment community, mortgage spreads (the difference between the yield on a mortgage-backed security and treasury bills) have increased or “widened.” What caused this? Concerns for the Fed.
One of the tools in the Federal Reserve’s quiver is quantitative easing, where the bank buys treasury bills and mortgage-backed securities in order to stimulate the economy. The Fed did this during the Great Recession and once again when the economy struggled in response to the coronavirus pandemic. Now that the economy is recovering, investors recognize that the biggest buyer of mortgage-backed securities will start to pull out. This prompted investors to sell mortgage-backed securities, and that sale resulted in a drop in book value per share.
Annaly has a portfolio diversification
Annaly employs different investment strategies that will perform better in different economic environments. The agency’s portfolio is designed for defensive characteristics (one of the reasons mortgage REITs are good candidates for an income portfolio). If the economy is struggling, investors will flock to safer assets such as government-backed mortgage-backed securities. Annaly’s credit portfolio is made up of loans that are unsecured by the US government, and these will outperform when the underlying economy is strong.
Annaly is actively engaging in direct mortgages, which is a business model similar to New Residential (NYSE: NRZ). Annaly focuses on providing loans to borrowers who are not eligible for traditional mortgages issued by Fannie Mae or Freddie Mac. These loans are called non-qualifying mortgages, and they are not guaranteed by the US government, which means that Anna takes a credit risk. These loans are nothing like the subprime loans of 15 years ago and are often aimed at professional real estate investors.
During the second quarter, Annaly reduced her holdings of government-guaranteed mortgage-backed securities by approximately 4.5% and increased her holdings of unsecured securities by 45%. This change makes sense in the global economic context of accelerating economic growth and rapidly rising house prices. Rising home prices mean loans are becoming more secure as borrowers are unlikely to default on a home where they have substantial equity. This helps support the valuation of the credit portfolio.
A dividend yield that isn’t too good to be true
Annaly Capital is one of the few stocks with a double-digit dividend yield, making it an attractive stock for many. income investors. While a double-digit return is often a sign of trouble for most stocks, mortgage REITs are not. At current levels, Annaly’s quarterly dividend of $ 0.22 represents a return of 10.4%. Mortgage REITs typically trade around book value per share, and book value tends to rise slowly (however, it can drop quickly!). The entire REIT mortgage space will have a cloud over its head as we wait for the Fed to exit the MBS market. Investors who are prepared to wait are certainly paid to wait.
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