Annaly: A 14% Dividend Yield Is Not Enough

| About: Annaly Capital (NLY)

The discussion of dividend yields from mortgage REIT companies such as Annaly Capital (NYSE:NLY) is a very hot topic on the investment websites where comments are allowed. Investors may need to step away from the yield discussion and take a look at the actual investment returns from Annaly Capital, especially compared to other investment choices.

In the current interest rate environment, Annaly faces a shrinking interest rate margin - the source of the company's profits and dividend payments. The challenge is that earnings from mortgage backed securities - MBS - are declining while the rate at which Annaly borrows money to leverage the MBS portfolio sits on a floor of basically zero percent short term rates. In the current interest rate environment it appears the company's net interest margin will slowly shrink unless a couple of things happen. If mortgage rates start to increase and borrowing rates stay level, net interest earned and cash for dividends will increase. If short term rates rise faster than mortgage rates, the interest rate spread Annaly earns could be squeezed very tightly, with the possibility of reduced or no dividend until rates change. One point investors must remember is that the rates on mortgages and mortgage securities may not track Treasury rates, especially in a rising rate environment. Mortgage lenders are selling into a very fragile housing market and an abrupt rate increase may freeze their new business.

A look at the long term - 10-year - share price chart for Annaly shows there is little chance for capital appreciation for investors. Annaly management makes it clear that the focus is to provide investor returns through dividend payments, but stock investors usually would like some share price appreciation along with the dividend yield. The share price pretty much camps out at $18 plus or minus $2, unless there is an interest rate upheaval and then the share price falls.

Investors are dependent on the dividends paid by Annaly with little hope for capital appreciation until the stock craters and shares can be purchased on the cheap. One example was the NLY share price drop from $20 to $11 over five months in the second half of 2005. Through the period, fixed-rate mortgage rates stayed fairly consistent, increasing from 5.6% in June of that year to 6.3% in December, 2005. However, the Fed has started pushing short term rates in the form of the Federal Funds Rate in early 2004. The Fed Funds rate rose from 1.00% to 4.25% from the start of 2004 until the end of 2005. The dividend from Annaly peaked at 50 cents at the end of 2004, then was lowered to 45 cents for a quarter, 36 cents and finally the company bit the bullet and dropped the payout to 13 cents per share. The dividend remained in the low teens for six quarters and was back up to 48 cents in late 2008.

The current comparable pattern for Annaly starts at the beginning of 2010. For the final quarter of 2009, the company paid a 75 cent dividend. The most recent distribution for the 2012 second quarter will be 55 cents, a 25% decline in the space of six quarters. During that period, Annaly has gone from earning 4.9% on its MBS portfolio to the 3.31% reported in the most recent earnings report. Currently Fannie Mae 30-year mortgage securities are yielding about 2.75% and the 15-year MBS well under 2%. The slow squeeze seems to be on as Annaly is experiencing constant prepayment rates of about 20%. That means one-fifth of the portfolio principal will be repaid over a year and must be reinvested into new mortgage securities.

In the current interest rate environment, the insidious danger to mortgage REIT investors is the slow erosion of their investment value while they cruise along, happy to be collecting a 13% to 14% dividend. Since the start of 2010 - to cover this recent period of declining dividend distributions - Annaly's share price is off about 5%. An investor holding the shares has given up about 80 cents in share price to collect $4.44 in dividends over the two year period. Even with the share price decline, the two-year return is a couple of points over 20%. Unfortunately, over the same time period, the S&P 500 is up 29% plus has paid several percent in tax-advantaged dividends. Of more interest to mortgage REIT investors is the fact that the Dow Jones Equity REIT Index is up 36% over the last two years. Investors focused on those 14% dividends have missed some very large moves in other REIT sectors.

The Annaly Capital share price is down 10% over the last year, which is not too bad considering the interest rate environment, but leaving investors with just a few percent net positive return. The information presented above should make it clear that historically the share price will continue to decline until rates definitely turn in favor of how the company manages its portfolio. The slow squeeze will not be attractive. The dividend yield will stay in the mid-teens, but if the share price declines by 10% or more over the year, after taxes on those dividends, an investor holding Annaly shares is just treading water.

Other mortgage REITs using the leveraged agency MBS strategy to produce a high dividend rate are American Capital Agency (NASDAQ:AGNC) and Capstead Mortgage (NYSE:CMO). These REIT stocks all face the same challenges. Result differences come from how each company manages its portfolio. A continuing decline in the market yields on mortgage securities will eventually impact every mortgage REIT.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.