Navigating mREITs: A Deep Dive into NLY’s Yield, Risks, and Opportunities

I’ve always been a fan of the mREIT business, which has historically produced solid yields in the right interest rate environments. This week, I want to dive into the space and highlight what investors should be paying attention to. Using NLY as an example, I'll break down how to evaluate the return profile and address some of the key risks that come with investing in mortgage REITs. The mREIT business is relatively simple: they earn returns by investing primarily in Agency MBS and using leverage to amplify those returns. The basic strategy is to borrow at short-term rates, typically through repurchase agreements, and invest in longer-term assets, earning the spread between the two, known as the net interest margin. Annaly also has a significant Mortgage Servicing Rights (MSR) portfolio, which investors should view as a predictable, annuity-like stream of cash flow.

MSR Background

MSRs provide the right to service a pool of mortgages, which involves collecting payments, managing escrow accounts, and remitting payments to mortgage investors. In return, the servicer earns a fee based on the unpaid principal balance of the mortgages. The fee is usually a fixed percentage of the UPB, meaning the revenue scales with the size of the mortgage portfolio. For instance, servicers might earn 25-50 basis points annually on the UPB. One of the key advantages of the MSR business is its operational leverage. The costs associated with servicing mortgages—staffing, technology, and compliance—are largely fixed. As the portfolio grows, these fixed costs are spread over a larger base, leading to higher profitability on incremental revenue. In other words, every additional mortgage added to the portfolio increases revenue with minimal extra cost, expanding profit margins. This operational leverage creates strong incentives for servicers to scale their MSR book, as it leads to substantial upside as the business grows.

On the balance sheet, the MSR portfolio is valued as the present value of expected future cash flows generated from servicing the pool of mortgages. MSR values are driven by interest rates, prepayment speeds, default rates, servicing costs, and the weighted average life of the loans. Most MSR books are marked to market quarterly, with prepayment speeds being a key factor. Importantly, MSRs act as a partial hedge against interest rate risk in a mortgage REIT's portfolio. MSR exhibits negative convexity which provides some hedge against rising rates (as prepayment speeds slow and the servicing cash flows extend), but they are not perfect hedges. In a falling rate environment, the decline in MSR values due to faster prepayments can be a drag on earnings. MSRs require careful management of prepayment expectations and interest rate risks to mitigate the downside impact of falling rates.

Risks to Consider When Investing in mREITs

There are several risks investors should be aware of when investing in mREITs. The core business model of mREITs involves earning a spread between the yield on assets (primarily MBS) and the cost of borrowing (typically via short-term repos). This spread can be significantly affected by changes in interest rates. When short-term rates rise, borrowing costs increase, which compresses the spread between the yield on MBS and the cost of funds, reducing profitability. In extreme cases, it can lead to negative returns. To manage this risk, mREITs employ a variety of hedging instruments such as interest rate swaps, swaptions, and futures contracts. These tools allow them to lock in borrowing costs or protect against rising rates. For example, Annaly uses interest rate swaps to receive floating rates and pay fixed rates, stabilizing the cost of its short-term borrowings. Another major risk is prepayment risk. When interest rates decline, borrowers tend to refinance their mortgages, leading to faster prepayments on the MBS portfolio. This forces mREITs to reinvest in lower-yielding MBS, compressing the portfolio yield and NIM. To mitigate prepayment risk, Annaly diversifies its portfolio with MSRs, which actually increase in value when prepayments slow. This provides a natural hedge, offsetting some of the income loss from MBS prepayments.

Leverage is a double-edged sword for mREITs. Most operate with 6-10x leverage, borrowing short-term funds to invest in long-term MBS. While this amplifies returns, it also magnifies losses and increases exposure to market volatility. Annaly adjusts its leverage based on market conditions, reducing leverage during periods of volatility or rate uncertainty to minimize exposure, though this comes at the expense of lower ROE. Liquidity risk is also a concern. mREITs rely heavily on short-term borrowing to finance long-term assets. During periods of market stress—such as the 2008 financial crisis or the COVID pandemic—liquidity in the repo market can dry up, making it difficult or expensive for mREITs to roll over their short-term borrowings. In extreme cases, mREITs may be forced to sell assets at depressed prices to meet margin calls. Annaly mitigates this risk by maintaining diverse funding sources, including repos, credit lines, and cash reserves. They also manage liquidity through stress testing to ensure they can meet obligations during periods of volatility.

Analyzing mREITs: The NLY Example

Let’s use NLY as an example of how investors should analyze an mREIT. To truly understand an mREIT, you need to dissect the balance sheet. Understand what assets are held, how they are financed, and the risks you’re exposed to. Most investors buy mREITs for income, as they are required to distribute at least 90% of their earnings to shareholders. Last quarter, NLY paid out $328 million in dividends to common stockholders and $37 million to preferred shareholders. With 501 million shares outstanding, that equates to a 65-cent dividend for common shareholders or $2.60 on an annualized basis, translating to a 13% yield. A 13% yield in an environment where short-term rates are declining and the 10-year Treasury yield is under 4% sounds attractive, but it’s crucial to understand the risks when investing in a REIT with a double-digit yield.

Let’s start with the MSR portfolio. NLY has a $2.8 billion MSR book, financed with just $600 million in debt. The MSR business generated $108 million in income for the quarter and $211 million for the first six months of the year. After amortization costs, the distributable income was $52 million for the quarter and $104 million for the half-year. If we annualize this and divide it by the shares outstanding, we get about 42 cents per share in income from the MSR business alone, which adds roughly 2% to the overall yield based on NLY’s $20 per share price.

The primary risk in an MSR portfolio is prepayment risk—the risk that mortgages will be refinanced or paid off early, shortening the servicing duration and reducing future cash flows. NLY manages this risk by using conservative prepayment assumptions and maintaining a diversified MSR portfolio across loan types and geographies. Another significant risk is default risk, where defaults lead to increased servicing costs and reduced revenue. However, given the strong credit metrics in NLY’s portfolio and the low average LTV ratio, large-scale defaults seem unlikely.

Agency MBS Portfolio

The biggest part of NLY’s balance sheet is the Agency MBS portfolio, which is valued at $64 billion. This portfolio primarily consists of FNMA securities, which carry no credit risk and have a weighted average life of over five years. NLY finances these MBS with $58.6 billion in repo debt and the remaining ~$6 billion with equity.

Currently, the portfolio’s weighted average yield is 4.91%, while the repo rate is around 5.6%, indicating a negative spread due to the yield curve inversion. However, this is where hedging comes into play. Hedging is critical in managing the duration mismatch between short-term borrowing and long-term assets. Annaly employs various hedging strategies to manage interest rate risk, with a primary focus on mitigating the impact of rising rates on its repo financing. The company uses a comprehensive hedging program that includes interest rate swaps, swaptions, TBA derivatives, futures contracts, and purchase commitments. These hedges play a crucial role in preserving NIM, which would otherwise be compressed by the rising cost of short-term borrowing.

The biggest risk that needs to be hedged away is the duration miss match between short term funding and long term assets. Annaly uses interest rate swaps where they pay a fixed rate and receive a floating rate. These swaps reduce the impact of rising short-term borrowing costs by locking in a fixed rate on a portion of their repo financing. In an environment where short-term rates are rising, the floating rates that Annaly receives through the swaps offset a portion of the increased repo costs, helping to maintain or reduce the compression on their NIM. Without these swaps, rising repo rates would directly eat into, and as we have seen recently, completely eliminate NIM.

For example, when we saw repo borrowing rates increase from 3% to 5%, the floating leg of the swap (which is based on the same or similar rate) will rise. Annaly receives more from the swap and pays the fixed rate, which is usually lower than the current repo rate, reducing the overall net borrowing cost. Using swaps NLY converts variable-rate liabilities, primarily repurchase agreements, into fixed-rate liabilities to protect against rising short-term interest rates. Currently the weighted average pay rate for the swaps was 3.13%, while the receive rate was 5.30%, with a weighted average maturity of 5.28 years. This swap reduces the short term repo borrowing rate from 5.6% to 3.6%, creating an economic net interest margin of 1.2%. Taking the NIM of 1.2% on $58B of financed Agency MBS generates interest income of 710M and 4.91 yield on the $5.7B in equity generates an additional $280M, to combine for roughly $1B in net interest income, or $2 per share.

The other risk is prepayment risk which shortens the expected cash flow period of their MBS holdings when rates decline. When borrowers refinance their mortgages or prepay the loan early, the MBS held by Annaly are paid off faster than expected, reducing the interest income they would have earned over time. In low-interest-rate environments, prepayment rates tend to increase, which leads to higher prepayments and forces NLY to reinvest the proceeds into lower yielding MBS. To mitigate this risk, they employ hedging strategies using swaptions and/or TBA derivatives. As rates decline homeowners are incentivized to refinance their mortgages at a lower rate. This leads to higher-than-expected prepayments in the MBS portfolio, which are paid off at par value. As a result, Annaly would lose higher-yielding assets that they are forced to reinvest in a lower-yielding environment. This decreases the expected income. NLY uses swaptions to partially mitigate this risk. Swaptions are typically used to hedge against the risk of falling rates by giving the holder the right (but not the obligation) to enter into a swap agreement in the future, where they can pay a fixed rate and receive a floating rate. Annaly purchases a swaption that allows them to enter into a fixed-for-floating interest rate swap in the future. This swaption will give them the option to hedge if interest rates fall further, leading to higher prepayment speeds. When interest rates drop and prepayment speeds increase, Annaly can exercise the swaption, locking in a fixed rate for their swaps and offsetting some of the impact of declining asset yields.

For example, Annaly might purchase a 2-year swaption that allows them to enter into a fixed-for-floating interest rate swap if interest rates fall further. This swaption would enable them to lock in a fixed rate, offsetting some of the income lost from prepayments. The ability to exercise these swaptions helps stabilize NIM, even when prepayment speeds increase.

Residential Mortgage Loans

In addition to its Agency MBS portfolio, NLY holds $20 billion in residential mortgage loans, financed with a 9:1 leverage ratio. About 15% of these loans are adjustable-rate mortgages. The average unpaid principal balance (UPB) is $476K, with an average interest rate of 6.12%, a credit score of 757, and an LTV ratio of 69%. To finance its residential mortgage loan portfolio, NLY uses securitization vehicles, primarily referred to as OBX Trusts. These securitizations are non-recourse financing transactions, where Annaly transfers residential mortgage loans to OBX Trusts as collateral. While these loans are legally sold for bankruptcy and state law purposes, they aren’t treated as true sales under accounting rules. The OBX Trusts then issue bonds to third-party investors, raising funds to purchase the residential mortgage loans. The bonds are backed by the cash flows generated from the underlying mortgages. As borrowers make mortgage payments, the cash flows pass through the OBX Trusts to the bondholders. Annaly, as the sponsor of the securitization, retains an interest in the residual cash flows after bondholder obligations are met (i.e., net interest margin).

Annaly benefits from these securitizations in several ways: The debt issued by the OBX Trusts is non-recourse to Annaly, meaning they are insulated from losses beyond their investment in the Trusts. Securitization allows Annaly to access a large pool of capital from bond investors, offering a more efficient financing source compared to traditional methods like repos. Annaly generates income from the residual cash flows of the OBX Trusts after bondholders have been paid. While these loans do carry some credit risk, the portfolio’s strong metrics suggest that this risk is minimal. Borrowers tend to have high FICO scores, and the average LTV of under 70% indicates substantial equity in the homes, providing a cushion in case of defaults.

Final Thoughts

Many investors tend to analyze mREITs based on book value, which offers a snapshot of the company's net worth at a specific point in time. However, I prefer to focus on the yield and carefully assess the risks that could lead to a dividend cut. This approach aligns with Annaly’s primary objective of generating net income for distribution to shareholders. By understanding the factors that could threaten the dividend—such as interest rate volatility, prepayment speeds, and credit risks—I can make a more informed investment decision based on the sustainability of the income stream. NLY is an attractive option for income-seeking investors looking for a double-digit yield with, in my view, low risk of that yield being significantly cut. Annaly's management has done an excellent job navigating the recent rising rate environment, where the yield curve inversion caused short-term funding rates to surpass longer-term asset yields. Through their effective hedging program, they’ve managed to protect the portfolio and minimize the impact on NIM. While these headwinds have compressed net interest spreads over the last two years, those challenges are starting to ease.

Looking ahead, I expect the yield curve to normalize, which should provide a tailwind for NLY and help expand their NIM. With no more hedges expiring this year, I don’t expect economic borrowing costs to rise much. The 3-month rate—a good barometer for borrowing costs—has already decreased by 70 bps since July and will likely continue to decline as the Fed cuts rates. In addition to the tailwinds from declining borrowing costs, I believe longer-term rates will remain stable, allowing the net interest spread to expand closer to its historical range of 1.5%+. This should drive higher net interest income and push the dividend yield closer to 15%, based on today’s share price of $20.

There is always the possibility that yield curves stay inverted for longer, and NLY’s hedges mature, leading to higher economic borrowing costs and compression in net interest income. However, even in that scenario, there is a decent margin of safety, allowing NLY to maintain a double-digit dividend while waiting for financing conditions to improve. An inverted yield curve is unsustainable over the long term, so any dividend cuts, if needed, should be temporary until the curve returns to normal.

I own shares at a ~$16 cost basis, which translates to nearly a 17% yield on my investment, and currently have no plans to sell, given the juicy yield in what I expect to be a declining rate environment. The management team has consistently shown its ability to navigate challenging market conditions, demonstrating they are well-equipped to capitalize on improving market dynamics—something I look forward to benefiting from as a shareholder.

Broad Market Update

I mentioned two weeks ago that I started adding short exposure following the FOMC bounce. So far, that call hasn’t played out as I expected, and my positions have mostly moved sideways over the past two weeks. The data this week reinforce the view that the labor market remains resilient, even as it cools. The rebounds we’ve seen in payrolls and JOLTS data should keep the Federal Reserve on track for a 25 bps rate cut in November. The market was clearly surprised by the stronger-than-expected jobs number. Private payrolls rose by 223K in September, compared to an expected gain of 125K. Goods-producing sectors are still underperforming. The manufacturing sector lost -7K jobs in September, continuing its weak performance throughout the quarter. Other areas in goods, particularly nondurables, also struggled. However, services more than made up for the slack, with 202K new jobs in September, well above the 3Q average of 130K. Leisure & hospitality (+72K) and health & social services (+73K) drove much of the gains, with professional & business services also rebounding with a 42K increase after a couple of softer months. The market quickly moved away from pricing in a 50 bps cut for November. It’s clear that the Fed will likely view the labor market as strong, but not overheating, which will allow them to focus more on disinflationary trends and broader economic concerns in their upcoming policy decisions.

From my perspective, this jobs report doesn’t change my outlook. I’m still skeptical about the soft landing scenario that many have priced in, and I continue to believe the quality of job growth remains low. I think knowledge workers making low to mid six-figure salaries, who carry a large portion of discretionary spend, are still at risk going forward. That said, I’m fully aware that the data hasn’t yet confirmed my suspicions. We’re also entering a seasonal period towards the end of the year that tends to be bullish. After two weeks of consolidation following the FOMC move, my leash has gotten much shorter on my positions. I’ll be ready to cut risk on the short side very quickly if I see the indexes break out. Earnings season kicks off next week, with the major banks set to report. This round of earnings will be critical to watch for 2025 guidance, and I expect the same trend as last season: companies that cut guidance will get punished hard. We should also get a much clearer picture of what 2025 earnings could look like based on the guidance and tone set by companies in this upcoming earnings season.