Is Annaly Capital Management, Inc.’s 11.7% Yield Safe?

Annaly Stock

Time to Lock in This Yield?

I like investing in mortgage real estate investment trusts (REITs).

In a sense, these little-followed firms work like banks, lending money at higher interest rates than it costs them to borrow. For example, a trust might buy residential mortgage-backed securities that yield five percent while its own borrowing cost is four percent.

That one-percent profit margin might not sound like much. But if the firm borrows $20.00 on every $1.00 of shareholder capital, this spread can turn into a 20% return on equity.

Of course, those big yields come with big risks. Specifically, mortgage REITs have a lot of exposure to changes in interest rates. But for firms that manage the risk well, this model can create a tidy stream of income.

One of my favorites is Annaly Capital Management, Inc. (NYSE:NLY). This trust has a storied reputation in the mortgage REIT business, paying out distributions for decades. But can this 11.7% yield possibly be safe? Let’s dig into the numbers.

The business squeezes out just enough cash flow to fund its distribution.

Last year, Annaly Capital generated $1.22 per share in core earnings. This metric serves as a good proxy for cash flow when it comes to lenders.

At the same time, management paid out $1.20 per share in distributions. Such a high payout ratio isn’t unusual, as you often see mortgage real estate investment trusts pay most or all of their profits to shareholders. Still, it doesn’t leave a lot of room for error.

Looking forward, analysts project Annaly’s operating and net income to grow by seven percent and five percent, respectively. We can expect core earnings to grow by roughly the same rate as well, leaving management with a little more breathing room.

Furthermore, management has taken measures to strengthen the company’s balance sheet.

At the end of the last quarter, Annaly Capital had borrowed only $6.90 on every dollar of equity on the books. This economic leverage ratio is considerably lower than where it stood in previous years, and well below its peers in the industry.

Why should you care? Because with the trust coming to the end of its deleveraging program, management can focus on shareholder dividends rather than paying down debt. A lighter debt load also puts the distribution on a much firmer footing.

The only thing that should keep investors up at night? Interest rates.

Analysts still expect the Federal Reserve to hike rates several more times over the next year or so. Higher borrowing costs could eat into Annaly Capital’s profits, reducing the funds available for distributions.

That said, management has seen this problem coming. Executives have hedged out much of their interest rate exposure through derivative contracts, which protects the company’s dividend in such a scenario. This seems like a sensible move, given the high possibility of more Fed rate hikes in the coming months.

In the short term, investors don’t have to worry about Annaly Capital’s ability to pay its dividend. I expect these distributions to keep rolling in as promised for at least the next year or so. But with such little room for error, shareholders need to keep a close eye on profits each quarter.

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