What Will It Take for Annaly Capital Management to Increase Its Dividend?

By Markets Fool.com

By paying a $0.30 dividend for five consecutive quarters, this marks the most stable dividend in Annaly Capital Management's 17-year history.

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However, while stable is certainly better than falling, investors must be wondering what it will take for Annaly to give its shareholders a raise. Here's my take on the possibilities:

1. Get lucky with rates
The first option would be if mortgage rates rise. Now, rising rates get a bad rap because, similar to falling stock prices, when mortgage rates rise, it lowers the market value of Annaly's currently owned securities. Since Annaly is basically a portfolio of bonds, lower valued assets makes the company less valuable and its stock price tends to fall.

OK, I will admit that sounds bad, but if mortgage rates increase, it gives Annaly the opportunity to buy new securities at more attractive yields. The new higher-yielding bonds help the company make more money, and more money leads to bigger dividends.

Unfortunately, mortgage rates are market driven and therefore difficult to predict. So, if Annaly is going to able to capture high-yielding securities in 2015, it will need a bit of luck.

2. Borrow for less
Option two is Annaly could reduce its borrowing costs.

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Annaly's borrowings have a floating interest rate that will increase and decrease based on short-term interest rates. As you can imagine, this leaves the company vulnerable to its costs of funds becoming more expensive.

To address this issue Annaly uses, among other similar tools, interest rate swaps. Essentially, this allows Annaly to trade its floating interest rate payments for fixed rates. The good news is that Annaly's costs of funds are locked in and not as exposed to rising and falling rates. The bad news is that in exchange for the protection fixed rates provide, Annaly receives a higher interest rate, which makes borrowing more expensive.

Currently, Annaly has about 50% of its borrowings covered by swaps. As you can see in the chart above, this is down significantly from 2013. However, if Annalywas to pare this number down further, it could decrease its cost of funds, make more money, and potentially increase its dividend.

With that said, while the Federal Reserve has suggested it will be patient with increasing short-term interest rates, the potential for the Fed to follow through is drawing closer. If Annaly does continue to reduce its use of interest rate swaps, it could leave the company vulnerable, so I do not see this as a fantastic option either.

3. Borrow more
Annaly's third option is to increase leverage. This measures how much debt compared to equity Annaly is using to make its investments.

The process is a lot like getting a mortgage on a house. If you put $10,000 down on a $100,000 house you have $9 of debt for every $1 of equity, which makes your leverage 9 to 1. Here's how this move helps Annaly: If your new house appreciated in value 10% -- and then you sold the house -- you could pay off your debt and double your investment.

Essentially, leverage can amplify returns. The scary part, however, is that the process works exactly the same in reverse and leverage can magnify your losses.

As of the third quarter of 2014, Annaly's leverage sits at 5.4 to 1. Considering the company has jacked this ratio up over 6.5 in the recent past, Annaly has plenty of wiggle room to up its use of debt, buy more securities, potentially create bigger returns, and increase its dividend.

However, according to the head of Annaly's agency portfolio, David Finkelstein, "[W]e have taken a conservative but opportunistic approach to both leverage and asset selection in 2014 and this has served us well and puts us in a good position going forward."

Basically, this means that Annaly is fairly comfortable with its current position. So, unless some great opportunity arises, it is likely the company will stay fairly conservative.

Will we see a bigger dividend anytime soon?
Based on what I am seeing today, in order for a dividend increase to happen, Annaly either needs to get lucky with mortgage rates, the Federal Reserve needs to push back increasing short-term rates, allowing Annaly to reduce borrowing costs, or Annaly needs to get reckless with its portfolio by amping up its use of leverage.

With that said, while I do not believe Annaly will increase its dividend anytime soon, I think investors need to hold on and keep a long-term perspective because Annaly should see more than its share of opportunity in the more distant future.

The article What Will It Take for Annaly Capital Management to Increase Its Dividend? originally appeared on Fool.com.

Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.