Read This Before You Buy Annaly Capital Management Stock

By Markets Fool.com

Annaly Capital Management has one of the highest dividend yields on the market at 11.4%, but before you buy any stock, it's important to know what you're getting into.

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Annaly is a mortgage REIT. Its business model could be simplified as being like a bank without the deposits. Annaly makes its money by borrowing on the short end of the yield curve and buying higher-yielding mortgages on the long end.

More specifically, it finances its portfolio primarily with repurchase agreements with an average length of 141 days to invest in mortgages with 15- and 30-year lives. The spread between its cost of funding and the yield it earns on its assets is its profit.

Annaly isn't without its risks. The primary risk is that spreads between short- and long-term yields compress, negatively affecting its spread income. Unlike traditional banks, Annaly is a price taker rather than price maker. It borrows on the wholesale market, exposing it to any fluctuation in interest rates. Banks, by contrast, have the advantage of setting their deposit rates, typically making quick adjustments to their deposit rates when rates fall, and increasing rates very slowly as rates rise.

Of course, Annaly has some methods for mitigating this risk. It routinely places hedges to reduce its interest rate sensitivity. In addition, Annaly uses significantly less leverage than traditional banks. The company is currently leveraged at 5.4:1, down significant from prior periods as the company repositions for rate hikes that many are expecting in 2016, if not 2015.

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Reduced leverage has the effect of generating less in "core" spread income, but with less risk. If long-term rates go up, negatively impacting the value of its long-term investments, the company's capital losses will be significantly lower, at 5.4 times leverage than at 10 times leverage.

Furthermore, it provides the company with the capacity to add leverage when rates rise, putting more capital to work when spreads are bigger. Because of the company's lower leverage, it just barely earned its $0.30 quarterly dividend rate, with "core" spread earnings of $0.30 in the most-recent quarter.

"Please don't pay us back early"
Because mortgage-backed securities tend to trade at a premium -- Annaly's cost basis for its investments sits at an average of 105.7% of the principal amount -- quicker than anticipated repayments from refinances or the sale of a home impact its profitability. In the absolute worst case, Annaly could pay $1.05 for $1 in mortgage principal, only to be repaid the next month at the $1 principal value.

Annaly's constant prepayment rate -- a percentage of principal balances paid off early on an annual basis -- came in at 8% during the December quarter. Should home prices tick up and borrowers move more frequently, it's likely its prepayment rate will rise, negatively affecting earnings.

One of the biggest difficulties with managing risk in mortgages is that borrowers can, at their option, make repayments on their mortgage by selling their home or refinancing their mortgage for a different term or rate. The lender, however, cannot force a borrower to pay early on a below-market rate loan.

A true jockey play
Perhaps more than any other financial company, an investment in a mortgage REIT is really a bet on the management team and its ability to forecast and predict changes in interest rates. It's practically impossible for a mortgage REIT to have any real durable, competitive advantage other than its manager's ability to manage the portfolio.

Whereas we can see through history that Wells Fargo's advantage isn't just its smart risk management -- it has historically paid much less for its core deposit funding than competitors -- outperformance from an mREIT comes solely through skilled risk management. Every mREIT has the same or similar access to funding, hedges, and mortgages. What differentiates good performers isn't the tools of the trade, but how the tools are employed.

And although Annaly has done well for its investors since its IPO, it has done so largely in a favorable interest rate environment. Interest rates have largely followed a general trend downward since 1997. Managing through a rising rate environment, in which rates are largely expected to only go up, will prove as a test for the mettle of its managers.

The article Read This Before You Buy Annaly Capital Management Stock originally appeared on Fool.com.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Apple, Bank of America, and Wells Fargo. The Motley Fool owns shares of Apple, Bank of America, and Wells Fargo and has the following options: short April 2015 $57 calls on Wells Fargo and short April 2015 $52 puts on Wells Fargo. 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.