Annaly Capital: As Prepayments Accelerate, Further Diversification May Be Needed

| About: Annaly Capital (NLY)

Min Zeng of the Wall Street Journal recently noted that, "U.S. Treasury bonds extended its losing streak with the benchmark 10-year note's yield threatening to break 3% again". This week's sell-off, now reaching a third straight day and possibly even a fourth when non-farm Payrolls are announced on Friday, has reignited the notion that a shift in the easy-money stimulus (previously established by the Federal Reserve during its spending spree of QE3) could be right around the corner. With that said, I wanted to revisit my previous analysis of Annaly Capital and reiterate my cautionary approach to this particular mortgage REIT.

In my last article regarding Annaly Capital's (NYSE:NLY) cautionary catalysts, I touched on the company's dwindling dividend and an obvious drop in mid-year assets. This time around, I plan on taking a closer look at how the current rise in real estate prices will accelerate prepayments and why diversification will be a key strategy if and when the Fed chooses to ease up on QE3-related spending.

Performance & Trend Status

On Thursday, shares of Annaly Capital -- which currently possess a market cap of $10.88 billion, a P/E ratio of 3.39, a forward P/E ratio of 8.39, a PEG ratio of 0.97, and a forward yield of 13.94% ($1.60) -- settled at $11.48. As of June 30, 2013, and from a cash and debt perspective, Annaly Capital had a total of $3.45 billion in cash and a total of $85.73 billion in debt on its books.

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Based on Thursday's closing price of $11.48, shares of Annaly Capital are trading 0.06% below their 20-day simple moving average, 2.58% below their 50-day simple moving average, and 14.96% below their 200-day simple moving average. These numbers indicate a long-term downtrend for the stock, which generally translates into a selling mode for most traders.

Although shares of Annaly Capital are in the midst of a prolonged downtrend, I actually think income-driven investors could find themselves a buying opportunity as shares continue to face the pressure of rising rates and the acceleration of prepayments over the next 12-18 months.

Rising Real Estate Prices Tend To Accelerate Prepayments

Rising bond yields tend to pressure the value of various types of fixed-income assets and leave those who have invested in such types of securities less protected. The interest income that is generated from owning these types of securities has dwindled and has the potential to be wiped out if a sizable drop in bond prices were to occur. That being said, a rise in real estate prices is also negatively affecting the near-term performance of names like Annaly, and I think it's best to highlight some of what's going on in the near-term.

Real estate prices are some of the biggest catalysts for a number of the non-agency REITs such as Two Harbors (NYSE:TWO) and Preferred Apartment Communities (NYSEMKT:APTS). When the prices pertaining to real estate begin to trend higher, the number of delinquencies tends to drop, and for those who invest in non-agency (non-government-guaranteed) mortgage-backed securities, performance tends to be on the bullish side. For most every bull, there must be a bear, and when housing prices begin to drop, non-agency mortgage REITs feel the pressure and shareholder value tends to evaporate, while agency mortgage REITs tend to move in the opposite direction.

Although the rise in real estate prices is great for many of the non-agency mortgage REITS, Annaly Capital and American Capital Agency (NASDAQ:AGNC) get the short end of the stick, since prepayment speeds tend to accelerate during these instances of bullish behavior in the real estate market. Why? As interest rates decline, high prepayments will mean that new investments are established at lower rates, thus shrinking net interest margins. When these margins shrink, agency-based mortgage REITs feel the subsequent pressure.

Diversifying For The Better

Annaly Capital recently announced the completion of its acquisition of Crexus (NYSE:CXS) which has since been renamed, Annaly Commercial Real Estate Group and in my opinion, the move itself, served two purposes. The acquisition was not only a strategic defense against a very unpredictable spending platform on behalf of the Fed and its third round of quantitative easing, but a clear diversification away from the firm's traditional agency-based RMBS investments.

When a majority of Annaly Capital's RMBS lose book value as the direct result of a rise in interest rates, the company's subsidiaries tend to traditionally see an increase in their own book values.

For instance, as David White points out, "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". When it comes to offsetting book value-related losses, Annaly, in my opinion, may need to consider a similar string of acquisitions that would help diversify its portfolio as a whole. Without diversifying its agency-based securities, Annaly may see a drop off in earnings and worse yet a significant drop in the face value of its shares.


For those of you who may be considering a position in Annaly Capital, I'd pay close attention to the company's continued efforts to implement a defensive strategy in the wake of any further QE3-related spending and the current rise in housing prices. If housing prices continue to rise and a long-term uptrend in these prices is established (and further sustained), prepayments will continue to accelerate at an even higher rate, and therefore a diversification-based strategy transforming Annaly from a pure-play agency mREIT to more of a hybrid agency mREIT must be seriously considered.

Disclosure: I am long NLY, AGNC. 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.