Are the temporary rate pullbacks and the resultant sizable bounce in mREITs enough to say that mREITs have bottomed out? I don't think so. The current quarter continues to be characterized by volatility in interest rates. Therefore, the future of Agency mREITs, particularly Annaly Capital Management (NLY) is dim.
Annaly Capital Management is famous for its elevated dividend yield. Currently, the stock is offering an unmatched dividend yield of 14 % on its quarterly dividend payment of $0.40 per share. The current dividend yield is much higher than the yield being offered by the 10-year Treasuries. However, investors must not ignore the immediate-term risks associated with an investment in Annaly Capital.
Volatility to prevail
Given the high probability of a QE3 taper in September, it is fair to expect interest rates and credit spread volatility will remain high during the third quarter. Also, the Fed will be getting a new chairperson in October. This will further increase volatility in interest rates.
This is particularly important for Annaly Capital as it doesn't behave well under increased interest rate volatility. For the past 9 quarters ended June 30, 2013, Annaly Capital provided 24% economic return per unit of volatility. This is one of the lowest among the mortgage REITs covered by Credit Suisse, only behind Hatteras Financial's (HTS) 20%. These estimates were provided by Credit Suisse analysts in their report on August 20, 2013.
Risk to dividends prevail
During the second quarter, the company earned an EPS of $0.47 per share of which $0.16 per share came from gain on sale of MBS (one-time item). After adjustments, core EPS comes out to be $0.31 per share. This is well below the current dividend rate of $0.40 per share.
So, it is evident from the above that Annaly's operating performance has not been able to sustain its current dividend rate, which means its future dividends are not safe.
More than expected book value declines
At the end of the second quarter, the book value declines reported by Annaly Capital and American Capital were 5% and 3% more than expected by Credit Suisse. Analysts at Credit Suisse now estimate another 7% and 4% declines in the book values of Annaly Capital and American Capital during the third quarter. Annaly Capital and American Capital reported book values of $13.03 and $21.51 per share at the end of the second quarter, respectively.
So, Annaly Capital is all set to report another set of disappointing figures as far as its third quarter book value erosion is concerned.
Sensitivity to rates
Estimated declines in book values are based on the sensitivities provided by mREITs in their quarterly SEC filings. Among Agency mREITs, CYS Investments (CYS) is worst positioned. It can report a 30% decline in its book value if rate go up 100 bps during the third quarter. This is followed by Armour Residential (ARR), which can report as much as 28% erosion in its book value. Annaly Capital and American Capital Agency are scheduled to report 20% and 6% declines under similar circumstances.
So, it is evident that Annaly's book value is exposed to significant risks if rates continue to increase or volatility prevails.
Calculating portfolio durations is another way of determining how exposed an mREITs book value is to changes in interest rates. Data compiled by Credit Suisse analysts reveals that CYS, ARR and NLY have actually increased their portfolio durations over the first quarter. Remember, higher portfolio duration during rising rates means greater book value decline.
Annaly Capital's portfolio duration extended by 1.4 years over the first quarter to 2.7 years. This is also the second highest duration extension among the Agency-only players. ARR's portfolio extension of 1.6 years is the highest. CYS extended its portfolio duration by 0.4 years, while American Capital Agency decreased its portfolio duration by 0.4 years.
So, again portfolio durations also reveal that Annaly's book value is highly exposed to moves in interest rates.
For some investors, the attraction of double-digit dividend yield is so much that they tend to ignore significant risks that threaten not only the dividend rate but also the stock price. Annaly Capital is faced with such risks. Its book value is highly exposed to changes in interest rates, and I believe the recent pullback in rates is only temporary. The volatility in rates will increase as the Fed begins QE taper. Given the backdrop, Annaly Capital is expected to report one of the highest book value declines.
Additional disclosure: Equity Whisper is a team of analysts. This article was written by our Financials analyst. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.