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A Beginner’s Guide to Annaly Capital Management

It’s easy to see why investors love Annaly Capital Management . With an 11.6% dividend yield, it’s one of the highest yielding stocks on the market today.

But is it a good stock for beginning investors? To help answer this question, here are three of the most important things that every new investor needs to know about Annaly:

1. A primer on mortgage REITs
The most important thing to know about Annaly is that it’s a real estate investment trust, or REIT, specializing in mortgage-backed securities, or MBS’s.

A REIT is simply an investment fund that owns income-producing real estate or real estate-related assets. Among other requirements, a REIT must invest at least 75% of its total assets in real estate assets and cash, and derive at least 75% of its gross income from real estate-related sources.

In Annaly’s case, it doesn’t invest directly in real estate, but rather in MBS’s. These are fixed-income securities, much like bonds, that are backed by residential mortgages.

Additionally, Annaly focuses on so-called “agency” MBS’s. This means that the securities are issued or insured by Fannie Mae or Freddie Mac, and are thus backed by the full faith and credit of the United States government.

This is an incredibly important point, because it means that, generally speaking, Annaly is insulated from credit risk — that is, the risk that its assets will default.

On Annaly’s most recent balance sheet, for instance, agency MBS’s accounted for $81.6 billion out of $88.4 billion in total assets.

2. Annaly’s biggest risk
The fact that Annaly has little to no exposure to credit risk doesn’t mean its business model is risk-free, because it certainly isn’t. In the place of credit risk, Annaly has to contend with interest rate risk.

Most mortgage REITs use leverage to buy assets. They borrow money at lower short-term interest rates and invest that money in higher-yielding long-term assets such as MBS’s.

In Annaly’s case, its $88.4 billion asset portfolio is funded by $13.3 billion in equity and $75 billion in liabilities — mainly debt. This means that Annaly is leveraged up by a factor of roughly 5.4 to 1 — the math doesn’t translate exactly because additional factors influence a REIT’s measurement of leverage.

The benefit of this model is that it magnifies shareholders’ return on investment. But the detriment is that it exposes REITs to potentially troublesome fluctuations in interest rates — i.e., interest rate risk.

Specifically, if short-term interest rates ever exceed long-term rates, which happens on an intermittent but not infrequent basis, then a company like Annaly would pay more to borrow money than it receives from its asset portfolio.

The good news is that there are ways to “hedge” against this eventuality. Annaly does so by buying interest rate swaps. These are financial derivatives designed to lock in the cost of financing.

In the most recent quarter, for instance, Annaly had outstanding interest rate swaps with a net notional amount of $31.5 billion. This means that roughly 42% of its funding costs are insulated against a rise in short-term rates.

3. Dividend payout
The reason that an otherwise mundane company like Annaly is such a popular stock stems from the size of its dividend payout. At present, shares of Annaly yield 11.6%. That’s almost six times greater than the 1.97% yield on the S&P 500.

As a REIT, Annaly must distribute at least 90% of its taxable income to shareholders to qualify for pass-through tax treatment. If it does so, then Annaly doesn’t have to pay corporate income taxes on its earnings.

This is a huge benefit when you consider that the top corporate tax rate in the United States is 39.1%. That’s the third highest general top marginal corporate income tax rate in the world, according to the Tax Foundation, exceeded only by Chad and the United Arab Emirates.

The one downside, however, is that Annaly can’t retain much capital to grow its book value, which, in turn, would fuel its share price. It’s for this reason that Annaly, and other REITs, are typically only attractive to income-seeking investors, not investors looking for capital appreciation.

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John Maxfield has no position in any stocks mentioned.

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A Beginner’s Guide to Annaly Capital Management Reviewed by on . It's easy to see why investors love Annaly Capital Management . With an 11.6% dividend yield, it's one of the highest yielding stocks on the market today. But i It's easy to see why investors love Annaly Capital Management . With an 11.6% dividend yield, it's one of the highest yielding stocks on the market today. But i Rating:
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