If you have read any of my previous articles covering mortgage REIT stocks, you know that I am not a big fan of the leveraged agency MBS business strategy. The problems with these stocks have been evident over the last several years as dividends have been slashed and the companies have used profits from the sales of securities to prop up even those lower dividend rates. However, with the recent dividend declaration by Annaly Capital Management (NLY), I think the MBS market and the company's plans give hope that the stock and dividend are both near a bottom.
The financial crisis, resulting economic recession and the Fed's qualitative easing programs to help the economy out of the recession set off a chain of events resulting in steadily lower mortgage and bond interest rates. Over the last four years, the agency mortgage REITs, including Annaly Capital, have been struggling with shrinking interest rate margins on their leveraged portfolios of agency MBS. As a result the dividends have been steadily reduced, and would have fallen even farther if the REITs had not cashed in gains on MBS prices due to the falling rates and used those gains to support the dividends. The NLY share price and dividend chart graphically tells the tale:
A Shift in the Markets
After sitting below 3.4% for most of the latter half of 2012, mortgage rates started to creep up in early 2013. The 30-year average rate reported by Freddie Mac hit 3.57% in March, and the rate was 3.54% for May. Now in June, the average rate has jumped significantly and the latest report has the 30-year rate to home buyers sitting a couple of basis points below 4.0%.
Annaly Capital Managed weathered the first quarter better than some of its peers, and I noted in my last article that the company had shifted some assets to higher coupon MBS, working to boost portfolio income. I also pulled the blind squirrel trick and forecast a $0.40 dividend for the second quarter. This past week, the company announced the dividend for Q2 would be $0.40, down from the $0.45 paid for the first quarter.
A Chance for Stability and Opportunity
Although rising mortgage and bond market rates will be a negative for the values of Annaly's MBS portfolio and the book value will take a hit for the second quarter. However, I think there are more positive than negative factors for the company's business going forward.
One event that will be very good for distributable cash flow is the completed acquisition of CreXus Investment Corp. CreXus was just a $1 billion company compared to the $12 billion value of Annaly Capital, but the commercial mortgage arm should be able to chip in steady and growing distributable cash flow.
It appears that the Fed's bond buying program will no longer keep the 10-year Treasury rate below 2% and agency MBS rates in the low 2's%. However, the Fed has more control over short term rates, and I expect those to stay near zero at least through 2014. As a result, the interest spread Annaly earns should start to widen. A wider spread means that the dividend coverage will come primarily from net interest earnings and whatever cash flow the commercial lending adds to the pot. This is a much more sustainable path to steady and possibly growing dividends compared to selling of appreciated MBS and distributing the profits.
Take a Position and Watch Carefully
At the current share price of $12.66, Annaly Capital Management yields 12.6% with a $1.60 annual dividend. With an entry at this price, I would give the company two to three quarter to show that distributable cash flow from net interest earnings and commercial lending has stabilized and growing. If that happens, this should be a good multi-year hold for investors.
Along the way, there may be some pain as far as the book value goes. Rising rates equals lower bond values producing a lower book value. The best market outcome for Annaly would be slowly rising mortgage and MBS rates, allowing the company to reinvest MBS prepayments without taking too much of a hit on book value.