Many income investors may be drawn to Annaly Capital Management (NLY -0.21%) because of its eye-popping dividend, which at the current share price yields more than 13%.
Like many real estate investment trusts (REITs), Annaly Capital struggled due to rising interest rates in the past few years. However, the tides may be shifting: In September, the Federal Reserve cut its benchmark interest rate for the first time since 2020. Many market participants expect that the central bank will continue cutting interest rates as long as inflationary pressures continue to subside.
With interest rates forecast to fall, Annaly Capital could be an appealing investment today while it's still trading below $21 per share. But there are some things that long-term investors will want to consider first.
Here's how Annaly makes money
REITs give investors real estate market exposure, and also offer attractive dividend yields, making them particularly appealing to income-focused investors. Most of them invest directly in leased properties such as retail centers, multifamily housing, data centers, or warehouses.
Unlike most REITs, Annaly Capital doesn't manage a portfolio of properties. It is a mortgage real estate investment trust (mREIT), so it invests in mortgage-backed securities -- pools of residential mortgages that are bundled and sold to investors. It invests largely in what are called agency mortgage-backed securities -- assets created by government-sponsored entities such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Those agencies guarantee the principal and interest payments on these mortgage investments.
Mortgage yields alone aren't very high, so Annaly uses leverage through repurchase agreements or other financial instruments to boost its returns. It aims to have an economic leverage ratio below 10. (That metric measures the ratio of its debt and derivatives divided by its total equity.)
What is important to understand here is that Annaly borrows capital on a short-term basis through its financial instruments while investing in long-term mortgage-backed securities. Essentially, Annaly earns money based on the spread between the yield on its assets and the cost of its borrowings. This makes it particularly sensitive to changes in the yield curve, which is the relationship between interest rates and time to maturity for an asset.
A poor performer for investors in recent years
In the past couple of years, interest rates across the yield curve have risen. On one hand, Annaly benefited as the yields on its interest-earning assets increased to 4.33%. However, the average cost of its liabilities also increased from 0.79% two years ago to 3.01% last year. As a result, its net interest spread narrowed from 1.89% in 2021 to 1.32% in 2023.
Annaly's sensitivity to interest rates has been especially noticeable over the past couple of interest rate cycles, starting in 2018 when the Federal Reserve began to raise rates. Since then, the mREIT's total return (which includes reinvested dividends) has been negative 0.4%. So, despite paying a dividend with a double-digit percentage yield, the value of the stock has fallen 58%, resulting in a net return of virtually nothing for investors during that time.
Why Annaly Capital could do well in the short term
The easing of monetary policy during the next year should benefit Annaly. A steep yield curve with low short-term interest rates and higher long-term rates would let it borrow at lower costs while investing in higher-yielding mortgage-backed securities. Its new investments over the past couple of years have raised its average asset yield from 2.61% in 2021 to 5.17% at the end of 2024's second quarter.
According to the CME FedWatch Tool, market participants are currently expecting 1.5% worth of interest rate cuts during the next year, and pricing the impact of those anticipated cuts into the values of various assets. These cuts would boost the book value of Annaly's portfolio, so they could provide a tailwind for stock.
However, longer-term factors could continue to affect interest rates. For example, JPMorgan Chase Chief Executive Officer Jamie Dimon has warned that growing fiscal deficits, global trade restructuring, increasing government obligations, and geopolitical uncertainty could make this decade more volatile than the previous one. For this reason, investors remain open to an environment where interest rates remain higher than they were during the 2010s.
Is it a buy?
Annaly could be an appealing buy for investors who want to make a bet on falling interest rates during the next couple of years. The mREIT should see its book value bounce back, which could be a tailwind for the stock in the short term.
That said, longer-term structural forces could result in higher interest rates than have prevailed in recent decades, and Annaly's sensitivity to the yield curve opens the possibility that it may have to cut its dividend at some point down the road. For that reason, long-term income investors looking for reliable passive income may want to look elsewhere.
