Will Annaly Cut Its Dividend?

At the end of last week, though before the Federal Reserve announced a third round of quantitative easing, I discussed the impact that such a move would have on Annaly Capital Management (NYS: NLY) and other mortgage real estate investment trusts like Chimera (NYS: CIM) , American Capital Agency (NAS: AGNC) , and ARMOUR Residential (NYS: ARR) . My thesis was simple and is best summarized by the chart below.

10-2 Year Treasury Yield Spread Chart
10-2 Year Treasury Yield Spread Chart

10-2 Year Treasury Yield Spread data by YCharts

As you can see, the size of Annaly's dividend is unmistakably correlated with the spread between short- and long-term interest rates. When the spread widens, Annaly's dividend grows. When the spread narrows, as it's bound to do in the wake of QE3, Annaly's dividend contracts.

With this in mind, it should be no surprise that Annaly was excluded from the rally following the Fed's announcement. Last Thursday, when all 30 stocks on the Dow Jones Industrial Average (INDEX: ^DJI) finished the day in the green, Annaly was down by nearly 1%.

The purpose of QE3 is to drive down long-term interest rates and mortgage interest rates in particular. To do so, the Fed will purchase $40 billion a month of federally insured mortgage-backed securities. The problem for Annaly is that these are the same securities that it buys to fund its dividend. Consequently, the resulting upward pressure on price courtesy of the Fed's move will increase Annaly's dividend production costs, and thereby reduce its distributable cash.

Here's how Annaly put it in its most recent 10-K:

We operate in a highly competitive market for investment opportunities. Our profitability depends, in large part, on our ability to acquire our target assets at attractive prices. ... [C]ompetition for investments in our target assets may lead to the price of such assets increasing, which may further limit our ability to generate desired returns. We cannot assure you that the competitive pressures we face will not have a material adverse effect on our business, financial condition and results of operations. Also, as a result of this competition, desirable investments in our target assets may be limited in the future and we may not be able to take advantage of attractive investment opportunities from time to time, as we can provide no assurance that we will be able to identify and make investments that are consistent with our investment objectives.

The counterargument
Now, there is an argument that the Fed's move will actually help Annaly by increasing the value of its MBS portfolio.

Douglas Ehrman, a member of The Motley Fool Blog Network, made this point in a post titled, "Annaly Gets Implied Fed Blessing" (emphasis added): "Under the recently announced plan by the Federal Reserve to begin a new round of quantitative easing, the Fed will buy $40 billion of mortgage-backed bonds each month. This move, targeted in the agency sector in which Annaly specializes, will increase demand for agency MBS. This is likely to drive the prices of those securities held in Annaly's portfolio higher."

Although Douglas makes a valid point, as Annaly's portfolio and therefore economic net income will invariably increase, he nevertheless misapprehends an essential aspect of a mortgage REIT's business model. Sure, they could sell off some of their portfolio, but in the absence of cash flow from interest or further share issues, they can't pay the dividends investors expect.

To add insult to injury, moreover, as my colleague Amanda Alix noted yesterday, lower mortgages rates spur refinancings, yet another threat to Annaly's bottom line. Again, according to Annaly's 2011 10-K:

We often purchase mortgage-backed securities that have a higher interest rate than the market interest rate at the time. In exchange for this higher interest rate, we must pay a premium over the market value to acquire the security. In accordance with accounting rules, we amortize this premium over the term of the mortgage-backed security. If the mortgage-backed security is prepaid in whole or in part prior to its maturity date, however, we must expense all or a part of the remaining unamortized portion of the premium that was prepaid at the time of the prepayment. This adversely affects our profitability.

Now, as I intimated above, funds like Annaly can account for the deficit by issuing new shares and using the proceeds to pay dividends. But as I've said in previous columns, doing so is both extremely suspect and unsustainable over the long term.

So, will Annaly cut its dividend?
It's hard to deny this possibility given the chart above and the statements made by Annaly in its 2011 10-K. At the same time, I believe Annaly has a history of back-filling cash-flow deficiencies with new share issues. Of course, whether it decides to use this mechanism now remains to be seen. Either way, however, investors would be wise to closely follow any developments in this regard.

To learn more about Annaly Capital Management and the safety of its monster dividend payout, read our recently released in-depth report on the company. It could easily save you from making a costly mistake. To access this report, as well as a year of updates on the company, click here now.

The article Will Annaly Cut Its Dividend? originally appeared on Fool.com.

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

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