The Fed Raises Rates: What It Means for Annaly Capital Management Inc.

On Wednesday, Dec. 16, the Federal Open Market Committee, or FOMC, decided to increase the federal funds rate for the first time in a decade. The increase will push the benchmark up from near zero to between 0.25% and 0.5%.

For mortgage REITs, or mREITs, such as Annaly Capital Management and American Capital Agency , rising rates means potentially tough sledding ahead. Rising rates can increase borrowing costs, cut into profits, and erode book value. However, I believe these companies have taken the necessary steps and are prepared to navigate this new environment. Let's take a closer look.

The problem As mREITs, these companies fund their investments in residential mortgage-backed securities by making short-term borrowings. The interest rate on this debt follows the federal funds rate. So when rates go up, borrowing gets more expensive.

Currently, the difference, or spread, between what it cost to borrow and the yield on their assets is just 1.2% for Annaly and 1.14% for American Capital Agency. As rates increase, these companies could see the spread narrow and cut into profits.

Long-term rates may rise as well -- such as the rate on 10-year Treasury bonds or the 30-year mortgage rate. When longer-term interest rates increase, it lowers the market value of the securities these companies currently own. Because Annaly and American Capital Agency are simply big portfolios of fixed-income securities, if there is a decrease in the value of their assets, then there will be a decrease in the value of the company.

Playing defenseThe Federal Reserve has gone back and forth about increasing rates for nearly two years, so the announcement comes as no surprise. In fact, mREITs have been preparing since mid-2013 by utilizing hedges and selling off assets.

The hedging tool of choice for most mREITs is interest rate swaps. This allows companies to trade their floating rate debt for fixed rates. It increases their borrowing rate, but it also locks it into place. As of the third quarter, 96% of American Capital Agency's borrowings and 58% of Annaly's borrowings were hedged with swaps. Annaly is seemingly more vulnerable, but they also have a greater percentage of long-term debt, as well as $1.8 billion in commercial debt investments -- which actually benefit from rising in rates -- and that helps to close the gap.

The second major adjustment was reducing assets. Since January 2013, Annaly has reduced assets by 40%, and American Capital Agency has reduced assets by 35%. Typically, these companies attempt to pump up returns by borrowing against their assets to purchase additional securities. However, if the value of their securities falls because of rising rates, this process also ramps up losses. The slimmer portfolios help to mitigate more dramatic losses.

An opportunity to play offense? In short, mREITs have been playing a ton of defense -- but that may change. Rising rates can reduce the value of Annaly and American Capital Agency's securities, but it also increases the yield on new securities. And since both companies have sold off a large chunk of their assets, they have the flexibility to add assets.

The potential to grow assets -- which would increase income and potentially lead to a bigger dividend -- has been the thesis for a while now. But with rates officially on the way up, it seems we're getting closer to having the thesis become a reality.

What to watch for?I would certainly keep an eye on the size of Annaly and American Capital Agency's portfolio. If either company ramps up, it would be a good sign that they are confident about the environment.

I am also going to be watching the FOMC's phrasing. As it stands today, the plan is to increase rates "gradually." This is the optimal scenario for mREITs, because a more modest pace -- predictions are saying one percentage point per year until 2018 -- gives these companies more time to adapt.

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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.

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