Is It Time To Buy Annaly Capital?

| About: Annaly Capital (NLY)

Annaly Capital Management Inc. (NYSE:NLY) is one of the largest, if not the largest, mortgage REITs in the U.S. It tends to be slower moving than many of the others. However, it also weathers the economic storms better than many of the others. NLY has gained roughly 500% since 1997. Over the same period the S&P500 has gained roughly 100%. NLY has performed approximately five times better than the S&P500 when you include both dividends and stock price appreciation. Plus it is more diversified that many other REITs. This can confer more safety, just as diversification is thought to confer safety on a stock portfolio.

NLY recently completed the acquisition of CreXus Investment Corp. (NYSE:CXS). This is now operated under the name Annaly Commercial Real Estate Group. The name itself should tell investors that CreXus was a diversification from NLY's core business of Agency RMBS investments. Other subsidiaries of NLY are Merganser Capital Management Inc. -- an SEC registered investment advisor, FIDAC -- another registered investment advisor, which externally manages Chimera Investment Corp. (NYSE:CIM), Charlesfort Capital Management Inc. -- a middle market lender, RCAP Securities Inc. -- a FINRA broker/dealer, and Shannon Funding LLC -- a warehouse lender.

The above diversity is important. When NLY's Agency RMBS lose book value in times of rising interest rates such as in Q2 2013, NLY's subsidiaries often gain in book value. For instance most CMBS were bought at huge discounts to face value. As the real estate market and the economy have improved they have gained in value. As the mortgage rates have risen the CPRs (constant prepayment rates) have decreased. This too causes the value of the CMBS to go up. This will tend to offset NLY's book value losses due to its Agency RMBS holdings. Of course, NLY is still new to the CMBS business. It has had little effect on results so far; but NLY only recently bought CreXus. Plus it intends to expand the CreXus business in future quarters.

In Q2 2013 NLY was just trying to limit the damage as Q2 was truly the quarter from hell. Long term U.S. Treasury yields and mortgage rates rose by approximately 100 bps in the space of a month and a half. Virtually all mortgage REITs loss significant amounts of book value. NLY was no exception. It lost -$2.16 in book value (from $15.19 as of March 31, 2013 to $13.03 as of June 30, 2013). This amounts to -14.2%. Most investors would not want to experience this. However, it is not likely to happen again soon.

NLY has tried to address at least part of the problem by significantly altering the makeup of its portfolio (see table below).

(Click to enlarge)

Investors can see that NLY delevered its Agency RMBS holdings from 6.6x to 6.2x. This would have been 5.5x, if not for the mark-to-market losses on its Agency MBS. By itself this deleveraging has made NLY safer. Longer term NLY plans to invest fully 25% of its assets in other than Agency securities such as CMBS. Again these changes are meant to make NLY less susceptible to interest rate changes (expected interest rate increases).

NLY had a bad Q2 2013; but it did perform decently compared to many of its peers (see the table below).


Stock Price at the close on August 30, 2013

Book Value Loss in Q2 2013

Book Value % Loss in Q2 2013

Book Value as of Q2 End 2013






American Capital Agency Corp. (NASDAQ:AGNC)





Armour Residential REIT (NYSE:ARR)





Hatteras Financial Corp. (NYSE:HTS)





AGNC outperformed NLY; but it has been doing that for some time now. Plus NLY is moving more quickly to diversify itself than AGNC. It may well soon be much safer than AGNC. NLY did outperform ARR and HTS on book value percentage loss by a good margin (less percentage book value loss). NLY is also a big company with a long history of success. It is easier to have faith in it. Its long, successful past gives investors every reason to believe in its future success.

The chart below shows NLY's improvement in net interest spread in Q2 2013, even with the decreased leverage.

(Click to enlarge)

The improvement from 0.91% to 0.98% isn't much; but it is progress in the right direction after the previous string of cuts. Plus NLY can expect to see its net interest spread rise further in Q3 2013 as interest rates and mortgage rates have risen. Lower volatility in Q3 and beyond may help too.

The only question then is, will the rapid rise in interest rates and mortgage rates continue unabated in 2H 2013. Most expect some rises. However, the amount of rise should be much less. The mortgage rate chart below shows that there has already been some rise. However, the degree of rise has been much less.

When you look at this chart, you have to take into account that rates rose throughout June 2013. Therefore the average figure for June is much less than the ending figure for June.

When you look further at the 30 year U.S. Treasury Bond yield chart (below), you can see that yields are not up overly much from the end of June 2013.

The rise in the last two months is worrisome. However, it seems to be predicated on the upcoming Fed tapering causing a large rise in rates. First countering this, a good amount of U.S. and world economic data indicates that rampant inflation is not likely in the near future. The World Bank and the IMF both lowered their world economic forecasts for 2013 recently. A number of U.S. economic data points such as the Durable Goods number (-7.3%) for July and the New Home Sales for July (394K versus an expected 485K) have been weak. These indicators do not suggest that rampant inflation is near.

Second the fear that Fed tapering will engender high inflation is overblown. The Fed has to taper just to keep its bond buying at the same percentage of each market it is buying in. The federal government has less of a deficit this year. It is getting 2.9% more in taxes due to the Payroll Tax reinstatement, etc. Plus the federal budget has been cut this year by the sequester. The effects of this are more 2H 2013 loaded. The Fed has to buy fewer bonds so as not to dislocate the U.S. Treasuries market.

With respect to MBS, the situation is much the same. With the rise in interest rates (and mortgage rates) refinancing activity has plummeted. Further we are starting to see the number of mortgages from home purchases fall a bit too. The Composite Index (a combination of the Refinance Index and the Purchase Index) clearly shows that many fewer new mortgages will be available this fall. Hence fewer can be made into RMBS; and the RMBS market should be smaller. With the higher mortgage rates, banks may also decide to keep more mortgages as investments. The Fed has to taper just so it does not buy all of the RMBS available (to keep its percentage buying of the market the same as in 1H 2013).

(Click to enlarge)

The above should be reassuring to investors; but does it mean you should buy NLY? It probably means you may wish to wait to see the results of the Fed tapering announcement. Many of NLY's peers bought a lot more interest rate swaps and swaptions to protect their book value recently. NLY has not done this. Instead it has adopted a longer term strategy which should work longer term. That said, NLY may take further book value losses in Q3 2013 due to the still rising interest rates and mortgage rates. The losses will not be as bad as losses in Q2, but investors may see the stock price fall again, when those likely losses are announced.

Of course, the above data about lower U.S. Treasury borrowing needs and lower MBS availability may eventually result in a pullback in interest rates and mortgage rates. This might mean little or no book losses for Q3 2013. Still it is probably prudent to wait at this time. The stock price of $11.60 is significantly below the book value (as of June 30, 2013) of $13.03. This represents something of a bargain. Plus the percentage loss NLY sees in Q3 is likely to be much less than that in Q2 2013. Therefore NLY is still a book value bargain; and you get to collect the gaudy dividend of almost 14% annually. Given NLY's long history of good management, this may be a good risk.

The two year chart of NLY provides some technical direction for this trade.

(Click to enlarge)

The slow stochastic sub chart indicates that NLY is neither overbought nor oversold. The main chart shows that NLY has been in a downtrend for many months. However, it also indicates that NLY may be bottoming. In fact in NLY's five year chart, there is good support at approximately $12. Investors may find that now will have been a good time to buy. Given all of the above, I wouldn't recommend jumping in whole hog. However, investors that like NLY as a long term investment may wish to begin to average in. This may be a turning point; and if it is not; a turning point is likely to be very close.

NOTE: Some of the above fundamental financial data is from Yahoo Finance.

Good Luck Trading.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.