If the Fed Keeps Cutting Interest Rates, This Stock Could Be a Winner

Annaly Capital Management (NYSE: NLY) looks like a dividend stock but doesn't act like one. This is hugely important right now as investors assess the potential for additional interest-rate cuts by the Federal Reserve.

Lower rates will probably be good for Annaly, but that's only important for investors who are looking for a total-return investment. If you're looking for dividend income, here's why Annaly has no place in your portfolio.

What could falling rates do for Annaly Capital?

As a mortgage real estate investment trust (REIT), Annaly Capital owns mortgages that have been pooled together into bond-like securities. These mortgage-backed securities (MBS) trade all day long on the open market. Furthermore, interest-rate changes can quickly affect the value of MSBs, including those held in Annaly's portfolio.

Rising rates tend to lead to falling bond prices since the price has to fall to increase the yield to current market rates. And falling rates tend to lead to rising bond prices since the price has to rise to reduce the yield to current market rates.

Image source: Getty Images.

That's not all, however, because mortgage bonds are also impacted by other things, including the state of the housing market. A good housing market can lead to more mortgages being available, while a stagnant housing market means fewer bonds.

Repayment rates are also an issue since falling interest rates often lead to consumers refinancing higher-rate mortgages. That removes mortgages from an existing bond pool and can change how investors price individual MBSs. There's a lot going on, which makes it rather hard for a small investor to closely track Annaly Capital, or any other mortgage REIT, for that matter.

But all in, falling rates will probably help Annaly. It could get even better if falling rates eventually lead to a spike in demand for housing (which will lead to higher demand for mortgages). That might bring banks back into the mortgage sector after they largely exited the market after the Great Recession.

More demand for mortgage bonds could lead to higher prices for the CDOs that Annaly owns, further increasing their price. If the Fed keeps cutting interest rates, Annaly could very well end up a big winner.

Dividend investors shouldn't take the bait

That's the good news. The bad news is that, despite a huge 13% dividend yield, Annaly is still a bad choice for dividend investors. The reason for this is fairly simple: Annaly's dividend isn't reliable.

Just look at the chart below. The dividend, represented by the orange line, has traveled a volatile path. The stock price, the purple line, has basically followed the dividend higher and lower over time. If you're trying to live off of the dividend income your portfolio generates, this isn't the pattern you want to see.

NLY data by YCharts.

This doesn't make Annaly Capital a bad company, however, because it isn't meant to be a dividend stock. It's a total return investment, which requires that you reinvest the dividends. If you do that, the material decline in the stock price isn't a big deal anymore.

The dividend payments are so large that they more than make up for the stock's decline provided you use them to buy additional shares. As the chart below shows, the total return here is a hefty 850%, versus a stock-price-only decline of about 60%.

NLY data by YCharts.

Annaly Capital is the kind of company that an asset allocator might like if they're including mortgages in their portfolio mix. This will likely be the realm of large institutional investors, like pension funds.

The potential upside for Annaly if interest rates decline moreis appealing, but only to a select group of investors. And that group doesn't include small individual investors trying to live off their dividend income.

Annaly is a specialty product

There's really nothing wrong with Annaly -- the REIT is doing exactly what it has set out to do. The problem is that the high yield tends to lure in income seekers who want to use the dividends to pay for everyday living expenses.

That just isn't the right way to think about this mortgage REIT (or most of its rivals). Even if the stock price rises as interest rates get cut, the very real risk that the dividend income here will rise and fall over time should stop income investors from buying Annaly.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.