Is this Sky-High Yield Too Good to be True?

Retirees and others that rely on income from their investments will be the first to tell you that interest rates are not what they used to be. Prior to the credit crisis, an individual with $2 million saved up could achieve a six-figure income just by holding a diversified basked of fixed income securities.

These days, locking your money up for 30 years with Uncle Sam will net you a yield of less than 4%. Ten-year Treasuries yield a stingy 2.6% these days, while money market funds essentially yield nothing. Add in the effects of inflation, and real rates are also next to nil.

The sad state of the yield curve has caused many investors to stretch for income, including forays into junk bonds and stocks with above-average dividend yields.

One of these stocks with above-average yields is Annaly Capital Management (NYSE: NLY). Annaly is a real estate investment trust (REIT) that invests primarily in mortgage pass-through certificates, collateralized mortgage obligations, agency callable debentures and other mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans.

As scary as that may sound at first glance, the business is relatively simple. Annaly borrows money and uses it to buy a portfolio of mortgage securities. Like a traditional bank, it earns a spread between its borrowing costs and returns it receives on its investments. The investments consist of securities that were created from packaging mortgages from single-family and multi-family residential homes, and to a lesser degree commercial real estate. At least 75% of its assets must be backed by the government, which these days consists of Ginnie Mae, Freddie Mac and Fannie Mae.

The company has profited handsomely from a steep yield curve , which is simply a chart of interest rates over a range of maturity dates, as it has been able to borrow at extremely low short-term rates, invest those funds in the above categories, and earn a high yield on those investments. High may be an understatement — the current dividend yield is 15.7%.

It’s easy to see why Annaly has caught the attention of yield-hungry investors. The bullishness is pretty widespread, as it’s difficult to find a negative or even cautious opinion on the stock. However, there are a number of potential pitfalls that warrant mention.

A review of Annaly’s risk factors in its SEC filings covers these pitfalls rather comprehensively. This section speaks to several factors. First, the mortgage-related assets the company invests in can be highly illiquid. Changes in laws and regulations in regard to Ginnie, Freddie and Fannie could hurt Annaly’s business. A change in interest rates could also impact the spread Annaly earns on its investments and could seriously dent its profitability. This could happen if short-term rates rise or long-term rates fall, which makes buying investments less appealing. Finally and most significantly, Annaly has significant leverage that it uses to juice profits.

The above risks are admittedly general in nature, and Annaly has been easily navigating them while returning impressive sums to shareholders. However, they do leave the company open to significant downside risk. A primary near-term risk is a jump in prepayments, which happens when individuals or commercial real estate owners refinance their mortgages to take advantage of lower rates. Annaly detailed that prepayments increased during its most recent quarter, though a fall in interest rates also reduced its funding costs. Mortgage rates have hit fresh all-time lows, so prepayments are likely to increase.

The most serious risk facing Annaly is another market dislocation that either bumps short-term rates, lowers long-term rates, or alters the upward slope of the yield curve in any way. The credit crisis served as a prime example of what this can do to companies, as firms including Lehman Brothers and AIG (NYSE: AIG) were hit with an inability to fund their businesses and disputes over the value of assets that became illiquid in sudden fashion.

Another example stems from a similar REIT called CRIIMI MAE , which went bankrupt in 1998. The Asian financial crisis caused the value of its mortgage backed securities to plummet in value just as its ability to obtain liquidity to fund its business collapsed. Annaly’s business is’t identical to CRIIMI’s, but it does demonstrate that an unforeseen financial crisis can hammer a highly indebted firm that invests in mortgage assets.

Action to Take —> Annaly has a number of significant pitfalls to navigate in running its operations. A market disconnect is the biggest concern, along with other risks exist, such as an unforeseen jump in short-term rates, higher than expected mortgage prepayment rates or regulatory changes in the mortgage market that adversely affect its profitability.

Given these risks, it is best to be on the safe side and conclude that its high dividend is likely too good to be true over the longer term.