Annaly's Dividend Coverage Has Improved but Longer-term Risks Remain

Annaly, the largest mortgage REIT, has lowered its dividend twice in the last two years, including a 12% cut announced in June.

As we discussed in May 2019, Annaly's dividend has looked risky under our Dividend Safety Score system for years.

While we continue to believe that mortgage REIT dividends are unreliable over a full economic cycle, Annaly's rightsized dividend is now better covered by core earnings.

With Annaly's payout ratio projected to fall below 90% next year to reach its lowest level in at least a decade, we are upgrading the company's Dividend Safety Score from Very Unsafe to Unsafe.

Over the short to medium term, we expect Annaly's dividend to remain stable due to the recent decline in borrowing costs and actions taken by the Fed to support the firm's primary market.

However, the nature of Annaly's business model makes it harder for the firm to pay reliable dividends over a full economic cycle, supporting our long-term Unsafe rating.

Annaly invests 93% of its portfolio in agency mortgage-backed securities (MBS). MBS represent claims to the cash flows from pools of mortgage loans, usually on single-family homes.

Importantly, the payment of principal and interest on these mortgages are guaranteed by government-sponsored organizations Fannie Mae, Freddie Mac, and Ginnie Mae.

As a result, substantially all of the agency MBS the firm invests in are AAA rated or carry an implied AAA rating, according to Annaly's 2019 annual report.

Given the minimal default risk of these MBS and today's low interest rates, Annaly's investments have yielded only around 3% in recent years.

That's not enough to support an attractive dividend, so Annaly uses leverage to boost its earnings and dividend power.

Annaly finances most of its investments using repurchase agreements, or repos.

With repos, the company pledges its investment securities (agency MBS, etc.) in exchange for short-term funding from broker-dealers, banks, and other lenders.

Annaly's repos have floating interest rates and typically mature within a couple of months. But most its agency MBS have fixed interest rates and long-term maturities.

This mismatch in duration and interest rate variability creates several headaches for management.

Periods of rising interest rates or a relatively flat or inverted yield curve decrease the spread between the interest payments Annaly earns on its long-term investments and the interest payments it makes on its short-term borrowings.

The Federal Reserve's decision earlier this year to slash interest rates to 0% reduced Annaly's borrowing costs, increasing the spread it earns and improving the near-term outlook for the safety of its dividend.

Management enters into interest rate swaps to mitigate some of the firm's rate sensitivity, but this requires making tough judgements about what the future might hold and how much exposure to hedge.

As of June 30, 2020 management estimated that a 0.75% increase in interest rates would reduce Annaly's book value by around 4%, all things equal.

Management would like to continue reducing Annaly's rate sensitivity and began diversifying the company into commercial real estate, residential credit, and middle market lending over five years ago. However, these businesses remain relatively small contributors to Annaly's overall earnings.

Besides interest rate sensitivity, Annaly and other mortgage REITs relying on the repo market can face funding concerns during downturns.

High uncertainty often triggers a flight to cash, removing liquidity from the market and causing repo market buyers to become more anxious about the value of certain securitized assets.

If the market value of Annaly's assets posted as collateral declines or repo market buyers require a larger margin of safety (known as a haircut), then the firm may need to provide additional securities or cash.

Agency MBS have a very strong credit profile, but the large size and strong liquidity of this market means it is often one of the first sectors distressed firms turn to when they need to sell investments to meet margin calls or deleverage.

As a result of this forced selling, plus fears of an impending mortgage refinancing wave due to falling long-term rates, agency MBS spreads widened during the pandemic-induced market turmoil earlier this year. 

During this period of uncertainty and funding pressure, from February 20 through April 3 shares of Annaly fell more than 60%.

Fortunately, the Fed stepped in quickly, assuring investors it would purchase agency MBS in whatever amounts needed to support the smooth function of this important funding market.

With the agency MBS market stabilizing and the Fed expected to keep short-term interest rates near 0% for at least the next few years, Annaly's outlook has improved.

Annaly's leading scale and more conservative use of leverage compared to other mortgage REITs also arguably make it the best house in a bad neighborhood, and its dividend looks more sustainable in the short to medium term.

However, an investment in Annaly is not for the faint of heart. Interest rate spreads, hedging gains and losses, repo market funding, mortgage prepayments, and use of leverage all create risks.

As a conservative income investor, my personal preference would be to invest elsewhere in stocks that have safer dividends, clearer paths to long-term growth, and more within their control, regardless of yield curves or the overall economic environment.