Does Annaly Have Hidden Credit Risk?

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Annaly Capital Management (NYS: NLY) is an incredibly popular stock. It pays a double-digit dividend yield, invests largely in riskless agency-backed mortgage securities, and is led by a CEO whom many consider an industry sage. It's even included in fellow Fool Dan Dzombak's high-yield dividend portfolio, which is beating the S&P 500 by almost 8 percentage points -- though it is one of the portfolio's worst performers.

While Annaly's shares are off since the beginning of last year, Fool analyst Jim Royal believes the mortgage REIT giant should be able to weather the storm without cutting its 14% dividend yield. I'm not as certain. In fact, I see a number of threats looming on Annaly's horizon. And although they may not be terminal or immediate, I do believe they will eventually cause the company's shareholders a non-negligible amount of pain.

What follows, in turn, is the second in a series of articles on what I believe are Annaly's biggest problems. To access the first in this series, click here.

The world of REITs
Real estate investment trusts come in a variety of shapes and sizes. Some, like Equity Residential, invest in multifamily properties. Some, like Health Care REIT, invest in health-care properties. Some, like Crexus Investment, invest in commercial property more generally. And some, like Annaly, invest primarily in residential real estate either directly or indirectly via residential mortgage-backed securities. The following table illustrates this variety.

Company

Investment Focus

Dividend Yield

Add to My Watchlist

Boston PropertiesOffice properties in Boston, Washington, D.C., San Francisco, and Princeton, N.J.2.2%Add
CYS InvestmentsResidential real estate15.3%Add
HCPHealthcare real estate including senior housing and medical offices, among other things4.8%Add
Host HotelsHotels1.3%Add
PrologisIndustrial distribution facilities and retail properties3.8%Add
Simon Property GroupRegional malls, premium outlets, community/lifestyle centers, etc.2.8%Add

Source: Yahoo! Finance.

In terms of mortgage REITs, you can break it down another level. In one camp, you have companies like Annaly, American Capital Agency (NAS: AGNC) , and Armour Residential (NYS: ARR) , all of which claim to invest exclusively in mortgage-backed securities that are guaranteed by a governmental agency like Fannie Mae, Freddie Mac, or Ginnie Mae. In the other camp, you have companies like Chimera Investments (NYS: CIM) and Invesco (NYS: IVR) , both of which hold a sizable portion of their portfolio in non-guaranteed mortgage-backed securities.

Company

Agency Securities as % of Total Mortgage-Backed Securities

Dividend Yield

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Annaly100%14%Add
American Capital Agency100%19.9%Add
Armour Residential100%18.3%Add
Invesco71%18.6%Add
Chimera47%16.7%Add

Source: Yahoo! Finance and S&P Capital IQ as of most recent quarterly data.

The distinction between these camps boils down to risk. Companies that invest in agency-backed securities are exposed primarily to interest-rate risk -- in this case, the risk that short-term interest rates will rise relative to long-term interest rates. Companies that invest in non-agency mortgage-backed securities, on the other hand, are exposed additionally to credit risk -- the risk that the underlying mortgages will go into default. It's generally fair to say, in turn, that companies in the latter category are riskier than those in the former.

Annaly's hidden risk
With these factors in mind, one would assume that Annaly exposes investors to less risk than many other REITs, as it claims to only invest in agency-backed securities -- Armour Residential and American Capital Agency excepted. The flaw in this logic, however, is that Annaly has derivative credit exposure through equity investments in Chimera and Crexus -- both of which hold a non-negligible portion of their portfolios in non-guaranteed securities. According to Annaly's most recent quarterly filing, it owns 45 million shares of Chimera and 9.5 million shares of Crexus. And as Fool analyst Anand Chokkavelu noted in his column on the worst mortgage REITs of 2011, both of these companies performed abysmally last year, offering negative dividend-adjusted returns of 25% and 10%, respectively. As a result, Annaly is carrying a $55 million unrealized loss on its books related to its investments in these companies.

It should be noted, moreover, that Annaly derives significant fee income from both of these companies as well. In the first three quarters of 2011, Annaly's wholly owned subsidiary FIDAC received $7.4 million and $39.2 million in management fees from Crexus and Chimera, respectively. These fees would be jeopardized in the event that either or both of these companies faltered -- which isn't totally out of the question if Chimera's recent share price performance is any indication.

Foolish bottom line
While Annaly's size allows it to absorb investment losses like those discussed above -- the losses account for less than 5% of its net income -- it nevertheless diverts income that would otherwise go to shareholders. And on top of that, it exposes its shareholders to a type of risk that isn't obvious at first glance. It's for these reasons that I prefer dividend stocks like the ones disclosed in our recently released free report "Secure Your Future with 11 Rock-Solid Dividend Stocks." While Annaly's dividend yield is admittedly huge, I don't think you can rely on it in the same way that you can rely on the stocks identified in this free report. To access the report while it's still available, click here now.

At the time this article was published Fool contributor John Maxfield does not have a financial position in any of the companies mentioned in this article. The Motley Fool owns shares of Chimera Investment and Annaly Capital Management.Motley Fool newsletter serviceshave recommended buying shares of Annaly Capital Management. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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