Thanks to its super alluring yield of more than 15%, Annaly Capital Management (NLY -0.57%) is one of the most popular mortgage real estate investment trusts (mREITs) on the market today. Last year was a rough one for mREITs. Rising interest rates increased the cost of borrowing, hurting mREITs’ earnings and asset values.
Annaly wasn’t spared from the challenges, and it has fallen 25% in the past year. The mREIT may look like an enticing buy considering the stock is down a good deal and its yield is nearly 10 times that of the S&P 500 average. But here’s why this is a stock I’d stay away from in 2023.
Out of its hands
Assessing a company’s growth opportunities and potential risks before buying is an incredibly important part of successful investing. Market conditions are a big factor in what growth opportunities and risks lie ahead and right now market conditions are not favoring Annaly.
The company invests in mortgage-backed securities (MBSs) insured by the government in addition to non-agency-backed mortgages not insured by the government (things like jumbo loans or loans on investment properties). It also has a growing mortgage-servicing unit that earns fees for servicing other lending institutions and investors’ loans.
Because mortgage REITs rely heavily on leverage to increase their returns, they are feeling tremendous pressure from rising interest rates, which in turn hurt profitability. Net interest margin, which is how much the company makes from the loans it buys after its cost of acquisition, has continuously fallen for Annaly since the Federal Reserve started increasing interest rates. As of the third quarter of 2022, its net interest margin was down to a mere 1.42%. Shrinking margins have led to a net loss per share under generally accepted accounting principles (GAAP) of $0.70 this past quarter.
Demand for MBSs in the secondary market has also dropped noticeably. The federal government purchased the bulk of MBSs from 2020 to 2021 through its quantitative easing program. But those purchased were halted in 2022. The Fed is slowly letting these assets fall off its books, which is hurting the values of MBSs.
The risks outweigh the reward
Annaly is exposed to risks from both sides of its business. It faces credit risk in its servicing arm and from non-qualifying mortgage loans in the event borrowers stop paying. It also confronts interest rate risk should rates rise more. Unfortunately for Annaly, both risks are out of the company’s control and are largely driven by the moves of the federal government.
Even if Annaly continues to do everything right — watching its bottom line, reducing its leverage exposure through hedging strategies, and continuing to expand its portfolio — it will be hard for the company to turn a profit without rates coming down and the housing market improving.
Right now home prices are in a downward trend leaving a growing number of homeowners underwater. Mortgage delinquencies are also starting to increase. The sector is still far from the housing crisis of 2008 to 2010, but it’s not headed in a favorable direction. Rates are expected to rise more slowly than this past year, but rate hikes aren’t over, which means 2023 could put more pressure on the stock.
Since the company is operating at a net loss, its lofty yield won’t be covered for long. It will need to generate positive net income to help it maintain those dividend payments or a cut will be coming. Annaly has underperformed the market over the last one, three, five, and 10 years. Since 2018 the stock has produced a negative return of 1.4% and has cut its dividend by 27%.
Annaly’s past performance, high-risk exposure, and unsustainable yield make it a stock I’m steering clear of for the foreseeable future.