What Can Annaly Do About Its Shrinking Dividend?

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In the world of real estate investment trusts, the mortgage REITs are the dividend yield kings. Mortgage REIT Annaly Capital (NYSE: NLY) is the largest company in the sector and lives up to the billing with a current dividend yield of 13.7%. Not that long ago, the yield was closer to 16% and when investors understand why the yield has declined, they will understand the risks involved with investments in Annaly Capital.

Other mortgage REIT companies include Chimera Investment Corp. (NYSE: CIM) with a yield of 14.3%, American Capital Agency Corp (NASDAQ: AGNC) with a dividend yield of 16.3%, Hatteras Financial (NYSE: HTS) yielding 12.6% and Capstead Mortgage Corp. (NYSE: CMO) with a current dividend yield of 12.9%. With a $16 billion market cap, Annaly is twice as big as the next largest REIT – American Capital Agency Corp. – and its value is more than the four listed companies combined. The large size for Annaly is an advantage, allowing the company to spread expenses over a larger portfolio of mortgage securities, reducing the cut into portfolio income. A subsidiary of Annaly Capital serves as the portfolio manager for Chimera Investment Corp. American Capital Agency Corp announced in early February a reduction in the company's quarterly dividend to $1.25 from the previous $1.40. The dividend had not been changed since the third quarter of 2009. Hatteras Financial also reduced its dividend to 90 cents quarterly from the previous $1.00. In 2011, the HTS dividend was reduced from $1.10.

Annaly Capital holds a portfolio of approximately $110 billion of mortgage backed securities. Of the securities held, 90% are fixed rate agency securities and 9% are adjustable rate agency securities – as of the end of 2011. The company boosts the income it earns from the portfolio by borrowing money to buy the majority of the mortgage securities held. The difference in interest earned on the mortgage securities less the interest paid on the borrowed money is the revenue source for Annaly Capital. At the end of 2011, the company had leveraged its own capital by a ratio of 5.4 to 1 through borrowed money to buy mortgage securities. The financial metric to watch is the interest rate spread between what the company earns and what it pays. In the fourth quarter of 2011, Annaly earned an average of 3.22% on its securities portfolio. It paid an average of 1.60%, leaving a spread of 1.62%. General and administrative expenses were 0.23% of the portfolio value.The company can also generate profits – and losses – from the buying and selling of the mortgage backed securities it owns. In the 2011 fourth quarter Annaly reported gains of $80 million from the sales of securities. Over the full year, net gains were $207 million. This number, however is relatively small compared to net interest earned, which came in at $3.1 billion for 2011.

Annaly Capital pays out the vast majority of its earnings excluding unrealized gains and losses. The 2010 dividends totaling $2.65 were 2 cents less than the earnings per share. The 2011 dividends of $2.44 were 95% of the reported net per share. Which leads to the big problem with Annaly Capital as an investment. The Wall Street consensus earnings estimate for 2012 is $1.95 per share, 24% lower than the 2011 results (of course, Wall Street could always be wrong). That said, I believe shareholders are likely to see the dividend payments decline in 2012.

The investor who thinks Annaly Capital is a good investment may note that a $1.90 dividend would still provide an 11.5% yield, much better than with almost any other investment choice. However, as the quarterly dividend declined from 65 cents in the second quarter to 57 cents at the end of 2011, the share price fell by 10%. The bulk of the share decline occurred when the dividend went from 65 cents to 60 cents when the third quarter distribution was made. What will happen to the share price if the dividend drops below 50 cents sometime in 2012? A 16% yield and a 45 cent quarterly dividend would put the Annaly share price at $11.25, one-third below the current value.

Market forces for interest rates and mortgage backed securities are putting the company between a rock an a hard place. Short term rates – which determine how much it costs Annaly Capital to borrow money – cannot get any lower and could possibly go higher. Mortgage rates are near all time lows and as the company's higher rate mortgage securities are paid off, the capital is being reinvested in lower yield securities. The company's interest rate margin contracted by 0.34 percent in the fourth quarter and it was the same amount lower than at the end of 2010. There is little Annaly management can do to support the dividend in the current interest rate environment. I think investors should wait until the spread starts to again expand and possibly wait for the share price to drop below $12.

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