One of the most intriguing mortgage assets to own today is "agency mortgage-backed securities" — a unique asset that removes the risk of the underlying borrowers defaulting on the mortgages, explains Rida Morwa, editor of High Dividend Opportunities.
Banks that originate mortgages are not interested in waiting for decades to get their capital back — they want to originate more mortgages to new customers.
So when an individual gets a mortgage, as long as the loan qualifies, the loan is quickly sold to "Government Sponsored Enterprises" (or GSEs) Fannie Mae or Freddie Mac.
Those agencies then repackage the mortgages into MBS and sell them to investors who are willing to sit back and collect the interest payments — hence the term "agency MBS."
In order to ensure investor demand, the GSEs include a principal guarantee. If the borrower defaults, the GSE will buy back the mortgage for the amount of principal still owed. This creates an asset where investors can receive mortgage interest with very minimal credit risk. Whether the borrower defaults or not, the investor is getting the principal.
So regardless of the credit ratings of the underlying borrowers, agency MBS always is AAA rated. Agency MBS is known as one of the most conservative investments outside of US Treasuries.
Agency mREITs like Annaly Capital (NLY) provide investors an opportunity to take advantage of this very strong asset class. Annaly borrows a significant amount of debt on their agency portfolio. Since agency MBS has very little credit risk, lenders are willing to lend a substantial portion of the buying price.
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It's not uncommon for mREITs to use leverage at 8-10x equity on agency MBS. As a result of utilizing so much leverage, the primary determinant of profitability of agency mREITs is the spread between the interest they pay and the interest they receive.
This spread already was improving in Q4 2019 thanks the declining interest rates, but it was kicked into overdrive in Q2 of 2020 as a result of the Federal Reserve dropping their target rate to 0.00%-0.25%.
The bottom line is that NLY make much more money when interest rates are stable or declining and does poorly when interest rates are rising. So timing is key. You need to know what you are buying into!
As investors, we can collect a +11% yield today, and for the next few years the interest rate environment is ideal for NLY's strategy. A high yield with dividend growth ahead? Yes, it's possible and its name is NLY!