Annaly: Is That Huge 13% Yield A Safe Bet?

| About: Annaly Capital (NLY)

In a world where you are lucky to get anything close to 1% on a bank account deposit of any kind, seeing a 13% dividend yield on a stock like Annaly Capital Management (NYSE:NLY) is very tempting. But how can a stock like Annaly Capital Management have such a high dividend yield and more importantly, how safe is that yield along with your capital investment?

What is Annaly Capital Management?

Annaly Capital Management is a real estate investment trust (REIT) - meaning it must distribute at least 90% its earnings in the form of dividends. But Annaly Capital Management is no ordinary REIT as it's a mortgage REIT that owns, manages and finances a portfolio of real estate related investments rather than physical properties.

Moreover, Annaly Capital Management is not the only mortgage REIT with a sky high dividend yield but do note that two of its "peers," Chimera Investment (NYSE:CIM) which has around a 15.5% dividend yield and Crexus Investment (NYSE:CXS) which has around an 11% dividend yield, are actually subsidiaries.

Other mortgage REIT peers with good size market caps of over $1 billion would include American Capital Agency (NASDAQ:AGNC) with a nearly 15% dividend yield, CYS Investments (NYSE:CYS) with a dividend yield above 14%, Hatteras Financial (NYSE:HTS) with a dividend yield approaching 13%, MFA Financial (NYSE:MFA) with a dividend yield nearing 12% and Two Harbors Investment (NYSE:TWO) with a dividend of about 14.5%. In other words, there is no shortage of investments to choose from in the world of mortgage REITs.

How Annaly Capital Management Generates That Dividend and the Risks Involved

Mortgage REITs like Annaly Capital Management generate income from the spread between the interest income received on the mortgages or similar types of instruments it owns and the cost of borrowing to acquire these instruments. Moreover and to further augment these returns, mortgage REITs will usually use leverage, like borrowing at low short-term rates in order to lend long. But, that can be dangerous should (or when) interest rates (eventually) rise as it will hit the profits of mortgage REITs and hence their dividends.

On the other hand, I would not expect interest rates to make any big moves in the next two or three years nor would I expect them to suddenly spike without warning. That means investors will need to watch mortgage REIT's conditional prepayment rates (CPR) - the percentage of principal that gets prepaid over a period of time and on an annualized basis. High conditional prepayment rates (CPR) means the sooner a mortgage REIT will need to reinvest in instruments paying a lower rate. In other words, it's like you or I owning a portfolio of bonds or CDs where some of the bonds or CDs mature - forcing you for better or for worst to buy new bonds at current interest rates.

That brings me back to Annaly Capital Management. Given its sheer size and market cap of above $16 billion (roughly its book value), I believe Annaly Capital Management would be the mortgage REIT that is the most susceptible to high or rising prepayment rates and hence, has the most risk of seeing its dividend yield start to shrink.

That's exactly what Wall Street believes will happen as so far this year. FBR Capital markets has downgraded Annaly Capital Management three times (ending with an Underperform rating), Compass Point has downgraded it twice (ending with a Neutral rating) and Wunderlich has downgraded it once (ending with a Hold rating). It's worth noting that in the last downgrade, FBR Capital markets did cite Annaly Capital Management's size as a risk for prepayments but it did not foresee a sudden prepayment spike. What FBR Capital did foresee was a constant 20% prepayment rate which will slowly erode the REIT's book value.

With that in mind, retail investors will need to watch how Wall Street and the big institutional investors react and whether they begin to trim their holdings. But, as of mid summer, I am not seeing any indication of that occurring just yet.

One reason for continued confidence in Annaly Capital Management by Wall Street investors as well as by retail investors like you and I would be its management team which tends to be on the conservative side. During the last investor conference call, Mike Farrell, Annaly Capital Management's Chairman, CEO and President, emphasized that rule number one is not to lose money and that the focus is on long-term shareholder value.

Nevertheless, Farrell did point out that he sees long-term risks associated with the general direction of US monetary policy and the impact of these policies on financial markets - risks that are hard to predict and control as they are in the hands of politicians and the Fed. Otherwise, Annaly Capital Management was also able to pleasantly surprise Wall Street with its second quarter performance as both the top and the bottom lines were far above the market's expectations.

Annaly Capital Management: The Final Verdict

If you are thinking of still getting into mortgage REITs in general, don't completely rule out investing in Annaly Capital Management so long as such an investment strategy is combined with a few of its peers or it's a low allocation verses your overall portfolio to minimize risk. After all if you are an income investor who really needs an investment that generates income, you will need mortgage REITs in general. Just be prepared to accept a lower dividend yield in the future and a possible decline in your capital investment.

If you are already a long-term investor in Annaly Capital Management, it might be time to take some of your profits off the table and perhaps not reinvest all of that dividend into more shares. Again, interest rates and prepayment rates are not going to shoot through the roof immediately and shoot investors in mortgage REITs like Annaly Capital Management. But you still need to be thinking a few quarters ahead and not just about this quarter or next quarter's juicy dividend payment that may not be sustainable for the long haul.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.