The mortgage real estate investment trusts (mREITs) have plummeted in 2013. My top two mREIT holdings, Annaly Capital (NLY) and American Capital Agency (AGNC) are down over 30% year-to-date. Investors who bought into NLY for the dividend yields of 12%-13% or into AGNC for the yields of 18%-20% are now facing losses that will require a few years of dividends to recover unrealized capital losses, assuming the share prices remain flat. But what sparked the sell-off? The sell-off has been in response to two major concerns; the belief that the Federal Reserve may slow or cease its mortgage asset purchases sometime this year and the fear that rising interest rates will crush portfolio holdings of the mREITs. The last wave of extreme selling occurred on Friday July 15th and was a direct result of another better than expected jobs number showing that the economy added 195,000 jobs in June. The next major catalyst for the mREITs is earnings. Both NLY and AGNC are scheduled to report their earnings on Monday July 27th. There is much speculation in the Seeking Alpha and investing community as a whole as to how these stocks will perform. One way to possibly help predict some of the action is to examine competitors who have reported earnings. This can provide clues as to what the other companies may have done in the quarter and can help individual investors decide whether they want to sell, buy more, or hold their positions into earnings. The mREIT earnings season began with CYS Investments (CYS) reporting its results on July 17th.
CYS Second Quarter Highlights
The first thing most investors look for is the earnings number. CYS reported earnings per share of $0.37, up 15.6% compared to the comparable quarter last year. This number is a bit misleading, however, because digging deeper we see that GAAP net loss was $402.3 million or $2.32 per diluted share, mostly attributable to a realized loss from investments of $211.4 million (there were other unrealized losses as well). One of the most important drivers of the share price in mREITs is the book value of the company. As of June 30th, the book value per share was $10.20, which is down 26% over the prior-year quarter. This number suggests that the stock which currently trades at $8.45, is about a 20% discount to reported book value. It is important to note that book value can change rapidly, and thus book value may have eroded further into July. However, interest rates have somewhat normalized in July (versus the rapid changes we saw in May and June), so it is likely still trading at a discount. I have suggested AGNC and NLY may have been trading below book value, so the CYS report lends some evidence that this may have been the case at the end of June. Other highlights of the results include a leverage ratio that went slightly down to 7.5 times and an interest rate spread that expanded 20 basis points (BPS) over the prior quarter to 1.36%. I have suggested management may reposition and either leverage up or down depending on the portfolio's performance. This leverage ratio is essentially stagnant from the 7.6 leverage ratio last reported so it doesn't lend much evidence as to what AGNC or NLY will do. I have suggested in the past the interest rate spread could be widening in the mREITs and this report confirms this thesis, at least for CYS. I will be watching closely AGNC and NLY's report for the reported interest rate spread and I expect it has widened, which is bullish for these stocks. One downside in the report was that during the quarter, expense as a proportion of total assets edged up to 0.98%. This was largely due to relatively flat operating expenses and lower average net assets.
Asset Purchasing And Yields
At the end of the second quarter, about 30% of CYS' portfolio assets were tied up in the 15-year fixed rate mortgage backed security (MBS). What is interesting to note is that this is nearly a 50% decrease from the end of the first quarter. During the quarter, CYS reported a hike in the yield it earned on its interest earning assets. Average yield on CYS' assets increased 30 bps, while the cost of borrowing funds increased by about 10 bps, yielding a 20 bps expanded net interest rate spread. What is interesting to note is that much of the hike in the asset yield was a result of the increase in the yields on the 15-year fixed rate MBS, which the company reduced during the quarter to reallocate elsewhere.
So where did the company reallocate? CYS rotated into the 30-year fixed rate MBS. According to the quarterly report the 30 year fixed MBS was 45% of CYS assets, which is a significant rise from 31% of the portfolio at the end of the prior quarter. Smaller portions of the portfolio were essentially unchanged, with CYS holding hybrid adjustable rate mortgages (15% of the portfolio) and the 20-year fixed rate MBS (6% of the portfolio. The large takeaway from this is that this action somewhat bucks the trend because while CYS sold the 15-year fixed rate MBS during the quarter and accumulated the 30-year fixed rate MBS, others, such as AGNC were actually selling 30 year. The 30-year is a risky play because it is sensitive to changes in interest rates. It remains to be seen what NLY has done with its holdings and what AGNC did in the remainder of the quarter. I stated they would reposition and CYS' quarterly report suggests the changes could be drastic compared to prior quarters.
Looking Ahead to AGNC and NLY's Report
Looking ahead to what could be in store for NLY it is heavily invested in the 30-year fixed rate Agency MBS which is what really hurt CYS's quarter. The decline in value of the 30 year led to a direct and extreme book value decline and with it a share price decline. It is quite likely that under the leadership of Wellington Dellehan, NLY will have taken some rebalancing efforts. Monitoring the performance of NLY's hedges will be another key aspect of their report. To help stop the bleeding of net asset value CYS lowered its leverage and picked up some commercial real estate loans in its assets, which are considered less sensitive to changes in interest rates. NLY has already taken measures to diversify into the commercial space. NLY's recent acquisition of CreXus (CXS) should help pad the top line revenue numbers and in turn bottom line earnings. While wholly dependent on the decisions made in the portfolio, with this diversification it is likely NLY suffered a smaller book value decline compared to CYS.
Turning to AGNC, we know that it was also heavily invested in the 30-year fixed rate Agency MBS. However, under the guidance of Gary Kain, the management team decided to dump some of the exposure to the 30 year in a portfolio re-balancing effort. The effect of this rebalancing could be dramatic. When coupled with the active management of assets and unknown performance of the hedges in place, it is unclear whether AGNC will see worse performance that CYS. However, the losses attributable to the 30-year selling will probably cause the company to report lower top and bottom lines than expected when the company reports. This is not all bad news however. The most recent quarter, and the current quarter now (Q3) are ones of transition for the entire space. The rebalancing of the portfolio, while painful to shareholders in the short-term is necessary to ensure long-term health of the company.
Examining the share prices of NLY and AGNC right now, they are trading at $11.60 and $21.21 respectively. While I expect both to report a decline and book value, I suspect AGNC's decline will be worse than NLY's. However, considering the current share prices, the book value reported for the end of Q2 is likely significantly higher than these share prices. In my opinion, most of the bad news is already baked into the share prices of these stocks. While I expect volatility after earnings are reported, I think they are both safe to hold through earnings, and more shares can be purchased on down days going ahead. Finally, I recommend all readers listen to both conference calls for the companies to gauge the overall market climate and how management feels they can continue to perform as well as they have in the past three years.