The macroeconomic discussion these days is dominated by talk of inflation and the actions of the Federal Reserve to bring it down. Futures based on the federal funds rate estimate that the central bank will raise the benchmark interest rate between 1.5% and 2% by the end of the year from its current level near zero. , which represents a significant tightening.
Real estate investment trusts (REITs) are very interest rate sensitive as they typically use a lot of borrowed money. Historically, mortgage REITs have provided some of the best dividend yields, but the waters seem to be choppy. here’s how Annaly Capital ( NLY 0.42% )one of the biggest names in this space, will likely navigate these waters.
The last two years have been difficult for mortgage REITs
Most REITs invest in real estate (for example, an apartment complex, office building, or shopping center) and then rent out individual units. Mortgage REITs don’t buy properties directly – they buy real estate debt. Instead of earning rent, they earn interest.
The COVID-19 pandemic has not been kind to the mortgage REIT space. At the start of the pandemic, liquidity dried up in the mortgage-backed securities (MBS) market and REITs were subject to margin calls. Many have been forced to offload investments at ridiculous prices in order to raise funds. Eventually, the Federal Reserve began supporting the MBS market via quantitative easing, which eased most of the pressure.
Federal Reserve returns to more normal policy
Now that the worst economic effects of the pandemic are behind us, the Federal Reserve is beginning to steer its fiscal policy toward a more normalized, non-emergency posture. That means raising the federal funds rate, but it also means ending its purchases of mortgage-backed securities and gradually shrinking its massive balance sheet. The change has weighed on the mortgage-backed securities market as investors fear it will translate into lower MBS prices in the future. In market parlance, this means mortgage-backed securities spreads are widening.
Widening MBS spreads during the fourth quarter pushed Annaly’s book value per share up from $8.39 to $7.97. And the trend of widening spreads continued into the new year.
Annaly is making adjustments to her portfolio that she hopes will offset some of the effects of the Fed’s policy shift. First, it is about getting out of debt, that is, reducing your dependence on borrowed money. Second, it is reducing its holdings of agency mortgage-backed securities, which are government guaranteed, and buying loans that are not government guaranteed. These unsecured loans pay higher rates and are less sensitive to Fed actions than agency mortgage-backed securities. Finally, Annaly invests in mortgage servicing rights – an esoteric asset class that rises in value as interest rates rise.
Takeaway for investors
Annaly’s share price was just beginning to recover to the levels it was trading at before the pandemic hit and reached $9.64 per share in early June 2021. Since then the share price has fallen around 26% as rumors of rising inflation turned into evidence of rising inflation.
At current levels, Annaly stock is trading at a 9% discount to its book value per share at the end of 2021. Additionally, it has just declared another dividend of $0.22 per share, which, at stock, gives the stock a yield of 12.4%. The company had earnings available for distribution of $0.28 per share in the fourth quarter, so its effective payout ratio is 78%, which is high, but not unsustainable for a REIT. Income investors may find the yield attractive. However, the Fed will make next year a tough race for the title.
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