Annaly Capital Management Inc (NLY-PF)

Annaly Capital Management is a mortgage real estate investment trust (REIT) founded in 1997 that specializes in purchasing and holding agency mortgage-backed securities and related assets. The company issues multiple classes of preferred stock, including NLY-PF, its 6.95% Series F Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock. NLY-PF represents a fixed claim on Annaly’s earnings from its mortgage portfolio, ranking ahead of common shares but subordinate to debt. The preferred shares are cumulative, meaning if dividends are cut or suspended, holders accrue the missed payments as a future claim.

The business is straightforward to describe and treacherous to manage: Annaly buys agency mortgage-backed securities (MBS)—pools of residential mortgages guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae—holds them on its balance sheet, and earns the net interest spread between what it pays for funding and what it receives from the mortgages. The primary risk is interest rates, not credit. When rates rise, the value of the existing MBS portfolio falls, eroding the company’s book value. When rates fall, existing MBS are at risk of prepayment, and new purchasing yields are lower.

Agency mortgage-backed securities: the core business

Annaly’s primary portfolio consists of agency MBS. These are securities backed by mortgages with explicit or implicit federal guarantees. Investors receive the promised cash flows—principal and interest—regardless of whether individual borrowers default; the guarantee absorbs the credit loss. This removes credit risk almost entirely from Annaly’s operations. The company does not originate mortgages, evaluate borrower creditworthiness, or manage loan servicing. It is a pure capital allocator buying and holding pools of mortgages originated and serviced by others.

The portfolio often represents over 85 percent of Annaly’s assets. At the end of 2025, the company held approximately $92.9 billion in agency MBS, nearly all of it carrying implicit AAA ratings due to government backing. This concentration is both a strength—agency paper is liquid and highly rated—and a vulnerability: the entire portfolio moves in the same direction when interest rates move.

Non-agency mortgages and mortgage servicing rights

Beyond agency MBS, Annaly holds a smaller portfolio of non-agency mortgages (residential mortgages without government guarantee) and mortgage servicing rights. Non-agency mortgages carry actual credit risk; they expose the company to borrower default. Mortgage servicing rights represent the right to collect fees from servicing mortgage loans. These segments are smaller than the agency portfolio but add meaningful diversification and complexity.

Non-agency mortgages have performed differently depending on the vintage and quality. Newer, well-underwritten non-agency mortgages have held up reasonably through recent cycles. Older or lower-quality vintages can deteriorate sharply in a recession. Mortgage servicing rights are exposed to prepayment risk—when borrowers refinance (typically in a falling-rate environment), the servicing fees dry up suddenly.

Interest rates: the primary lever and the primary risk

Annaly’s profitability swings on interest rates. Here’s the mechanical picture:

When rates fall: MBS already held at higher yields become more valuable, so the portfolio appreciates. But falling rates trigger refinancings—borrowers prepay old mortgages and take new ones at lower rates—so the portfolio shrinks. The company is forced to reinvest proceeds in lower-yielding new securities. Net interest income (what the company actually earns) compresses because the spread narrows. The accounting gain from portfolio appreciation is real, but cash earnings fall.

When rates rise: MBS held at lower yields become less valuable, so the portfolio depreciates. But rising rates reduce refinancings—borrowers keep their old mortgages—so the portfolio duration extends. The company earns higher reinvestment yields on new purchases. The accounting loss from portfolio depreciation is real, but cash earnings improve.

The problem is asymmetry. In a rising-rate environment, Annaly’s book value falls sharply, but operating earnings improve gradually. In a falling-rate environment, the opposite occurs: book value rises but operating earnings compress. This mismatch creates volatility in reported earnings and pressure on preferred dividends if the company’s capital is impaired.

The hedging strategy and its limitations

Annaly uses hedges—primarily interest-rate swaps and swaptions—to mitigate the risk that rising rates erode its portfolio value. When rates rise, the hedges gain value, offsetting some of the portfolio loss. This sounds elegant in theory. In practice, hedges are imperfect and costly. They reduce upside potential (when rates fall and the unhedged portfolio appreciates, the hedges lose money, offsetting gains). They also require disciplined execution; misjudging the rate environment can leave the company under- or over-hedged.

In recent periods, Annaly has shifted to what it calls a “prudent hedging approach,” actively hedging near-term interest-rate risk while accepting some longer-duration exposure. The intent is to stabilise near-term earnings while still participating in longer-duration opportunities. The execution is complex and requires ongoing management. A poor hedging decision or a surprise in interest rates can still derail earnings materially.

Leverage and capital structure

Like most financial institutions, Annaly finances its portfolio with debt. It borrows at short-term rates (often floating), buys MBS with longer maturities (fixed or floating), and captures the spread. This creates a classic interest-rate mismatch: if short-term rates rise faster than long-term MBS yields, the spread tightens or inverts, and earnings suffer.

The company also uses leverage—it borrows multiple times its equity capital to invest in MBS. This amplifies returns when the strategy works but magnifies losses when it does not. A decline in MBS values can quickly erode equity capital, forcing the company to cut leverage (sell assets, pay down debt) at potentially unfavourable prices or cut dividends to preserve capital.

NLY-PF holders, as preferred shareholders, are subordinate to debt holders. If Annaly’s capital deteriorates, preferred dividends can be cut before debt is impaired. The cumulative nature of NLY-PF means holders accrue the missed payments, but there is no guarantee they will ever be paid if the company’s profitability remains suppressed.

The macro environment and concentration risk

Annaly’s entire business depends on the residential mortgage market functioning and on interest-rate cycles that create opportunities to profit from spreads and positioning. A severe housing recession that spike non-agency defaults, or a sustained low-rate environment that compresses spreads permanently, could impair earnings for years.

The company is also implicitly exposed to government housing policy. Changes to Fannie Mae or Freddie Mac, or shifts in policies affecting mortgage origination, could alter the supply and characteristics of MBS available for purchase. The company has no control over these forces and must adapt to policy shifts.

Segmented view: how risk accumulates

Agency MBS provide credit safety but interest-rate sensitivity and prepayment risk. Non-agency mortgages introduce credit risk but provide higher yields and some diversification. Mortgage servicing rights add cash flow but are vulnerable to prepayment spikes. Leverage amplifies all of these effects. Hedges reduce some risks but create new ones and carry costs.

For NLY-PF holders, understanding which risks are most likely to manifest is crucial. In a rising-rate environment, portfolio depreciation and leverage pressure are severe, and hedges may not protect adequately. In a recession, non-agency mortgage losses could surprise. In a stagnant, low-rate regime, spreads compress and earnings disappoint. The preferred dividend is safe in normal times but at real risk in stress scenarios because the preferred claims are subordinate to debt and because Annaly’s capital can deteriorate quickly under adverse conditions.

The company manages these risks actively and has survived multiple cycles. But preferred shareholders are not creditors; they bear equity-like risks and are paid fixed income, a structural mismatch that makes NLY-PF a cyclical income instrument rather than a stable dividend play.