By Stephen Leeb, Income Performance Letter

Mortgage REITs seem to be an income investor’s dream come true. As is typical for almost any investment, free lunches are rare, and high dividends always come at a risk.

But we don’t want to be left on the sidelines, either; mortgage investing is a legitimate business, and top-quality mortgage-backed securities (MBS) are a solid investment. We think our old friend Annaly Capital Management (NLY), which is rejoining our High-Yield Income portfolio, knows how to do this properly.

Annaly has long experience as the largest publicly traded US mortgage REIT. Unlike most of its competitors, Annaly’s portfolio is more heavily invested in US residential mortgage-backed securities issued by government-related agencies, including 30-year mortgages. 

As conventional mortgage rates declined to record lows, Annaly’s portfolio suffered because of higher prepayments; but management has used this opportunity to sell high-yielding legacy assets for gains during the last quarter.

Also, compared to the competition, Annaly’s use of leverage can qualify as conservative, with about 5.5 times debt-to-assets leverage compared with 8 to 10 times for the rest of the industry.

Management has indicated this current level of leverage will remain constant until further clarity around both the macro environment and Presidential election is reached.

We think this is a positive factor, given that even with its current  leverage (and after the recent dividend cut) Annaly is able to generate a dividend yield of 14 percent.

The current rock-bottom interest rate environment has been very favorable for mortgage REITs. But the downside is that they are more vulnerable to interest rate hikes than equity REITs.

When short-term rates rise, mortgage REITs will see their financing costs go higher without a corresponding rise in revenue.

However, given that the Federal Reserve has pledged to maintain benchmark rates at essentially zero through at least late 2014, the environment for mortgage REITs should remain favorable for quite a while.

Mortgage REITs are also subject to prepayment risk: When borrowers pay off their
loans sooner than scheduled, future interest payments are lost.

If prepayment rates increase, that too could threaten the ability of mortgage REITs to sustain their generous dividend levels. Annaly Capital Management recently reduced its dividend for this very reason.

Even if more cuts are in the cards, we wouldn’t worry; the shares are attractively valued at slightly more than one time book value, and risks and rewards are well balanced here. For strong dividends going forward, buy both Annaly Capital  Management.

Related articles:

• MV Mortgage REIT: Double digit yield
• American Capital: A cash machine?
• Annaly: Preferred play on mortgages