The agency mortgage REITs, with Annaly Capital Management (NYSE:NLY) as the largest of the bunch, claim to safely leverage AAA mortgage backed security yields to produce double-digit dividend yields and at the same time hedge away most of the interest rate risk. The high yield with safety story of Annaly Capital and other mREITs took a bruising starting in the Fall of 2012 and through most of 2013. Annaly has recovered some of the losses since the December 2013 lows, but remains well below the average share prices in effect from mid-2009 until mortgage rates started to increase in the second half of 2012.
I have long discussed my thoughts on how the hedging strategies of mortgage REITs would not stand up to rapidly changing interest rates. A 40% drop in NLY over the course of a year shows that what the company was doing did not work very well in the face of rising mortgage rates. With mortgage rates back down from the peak reached last year, I wanted to take a look at the NLY returns over the cycle of rates up and then back down. I think the five-year charts showing the average 30-year mortgage rates compared to the Annaly Capital share price tell the story.
Spending MBS Capital Gains
On the charts below, the highlighted areas cover from July/August 2009 through September/October 2012. Discussion to follow:
During this period, mortgage rates moved steadily lower as the housing market remained in the doldrums following the financial crisis. Over the highlighted time frame, the average 30-year mortgage rate dropped from 5.2% to 3.4%. With rates dropping by 1.8% over the two years, MBS prices would have moved up significantly.
Over the same timeframe, the NLY share price remained in a level trading range, starting and ending the period at about $17.50 per share. During the period, Annaly paid $8.13 in dividends, or about 15% per year in yield. However, the quarterly dividend rate declined by 30% over the period from a high of $0.75 near the start to $0.50 for the last dividend paid during the highlighted period. As I covered back in August 2012, Annaly was using capital gains from bond sales to help prop up the dividend. As a result, you get the level share price even as MBS prices were rising. Those higher values were included in the dividend payments.
Rates Rise, MBS Prices Fall, Leveraged MBS Portfolios Fall Farther
These next set of charts shows the somewhat unexpected rapid increase in mortgage rates starting in late 2012. As MBS prices fell, so did the NLY share price.
In the highlighted timeframe, the average mortgage rate climbed from 3.4% up to a peak of 4.5%. From the $17.50 level of September 2012, the NLY share price had declined by over 40% to the December 2013 low of about $9.75. Over the same period, the dividend rate was also reduced by 40%. Factoring in the $1.20 in dividends paid, in just over one year the losses equaled 80% of the dividends paid over the preceding three years. Investors who had purchased anytime after the middle of 2010 finished 2013 with net losing positions.
Better Recovery in 2014
The next pair of charts covers from when mortgage rates peaked and the NLY share price bottomed up to the present.
From the FRED tables, mortgages now have dropped back down to 4.1% from the 4.5% high. The NLY share price at the current is 20% above the December 2013 lows. A $0.30 dividend has been paid for the last three quarters. Without capital gains to harvest, the rise in MBS values from falling rates shows up in the book value and share price.
However, with one more set of charts, I would like to show the damage that can occur to mREIT investor holdings when mortgage rates are move volatile:
These charts highlight the time period from when the average mortgage rate hit 4.1% on the way down, dropped further to 3.4%, climbed to the 4.5% peak and is now back to the 4.1% starting point. The whole cycle covers right at two years. The NLY share price is now $5.80, or 33% lower than it was two years ago. $5.32 in dividends have been paid, negating most of the loss, at least before taxes. In comparison, the stock market is up about 30% over the same two years. Finally, the NLY dividend rate has been reduced by 50% over the period.
The results from Annaly Capital over the two years of mortgage rate cycles are pretty ugly. However, the stock price is trending up, so as these two charts push out into the future, the negative effects of rate volatility may lessen.
Conclusions or Lessons Learned
Agency mortgage REITs like Annaly Capital Management need stable or falling mortgage rates to produce reasonably attractive returns. If you think mortgage rates will again go up, this is not a stock to have in your portfolio.
The harvesting of MBS capital gains to support the dividend when rates are falling is the shovel that will dig the hole when rates turn upward. Mortgage REITs are handcuffed by the REIT rules requiring that 90% of income be paid as dividends. If both mortgage rates are falling and the REIT's dividend rates are falling in spite of paying out capital gains, there will be an unpleasant end to that trend when rates turn upward.
So far into 2014 a relatively soft real estate market, especially when purchases are financed, are keeping mortgage rates down. In the current environment, Annaly should generate enough cash flow to maintain the dividend. There may also be some additional share price gains, but investors in NLY must keep a wary eye on mortgage rates and be ready to sell if the mortgage lending market heats up.
In future articles, I plan to use the FRED mortgage rate charts to see how other mREITs fared over the different timeframes.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.