A brief guide to the perplexed about Annaly Capital Management (NYSE:NLY)
Annaly Capital Management looks tempting. Its dividend is over 13%, it's at decade lows, its chart appears to be bottoming, and tepid U.S. economic data leads many to believe that the spike in rates from the Fed taper speculation is done.
Investors have noticed. It appeals to the yield seeker and bargain hunter in us all.
It seems that hardly a day passes without another article on NLY appearing on seekingalpha.com, often among the top 10 most widely read. Like Linn Energy (LINE) did a few months ago (when Barron's trashed it and sparked a massive debate and stream of articles pro and con on the MLP), it seems like it may be an ideal income play for those with some patience and risk tolerance. After all, NLY has been around for a long time and so in theory has the management skill to ride out the ongoing interest rate volatility that has pounded its share price.
However, while markets do overreact, they generally don't send stocks to decade lows without good reasons, and only a fool would fail to regard its junk bond like dividend without suspicion.
It's time to get some clarification on NLY. The Fed is widely expected to initiate tapering at its September 17-18 meeting. That fact alone might prompt investors to hold off on new positions or to lighten up to reduce risk of another rate scare-induced plunge. However, NLY should declare its quarterly dividend towards the end of September, and no one who has been holding NLY wants to miss that.
The Questions You Must Answer
Here are the key questions to answer in order to determine if whether NLY is a bargain or falling knife.
Mortgage REITs like NLY are not my specialty, so here are the questions I'm dealing with in trying to answer in order to determine if whether NLY is a bargain or falling knife.
Here is a summary of the bullish arguments for NLY, and my questions about them.
1. Insider buying: like most mREIT managers, NLY's management was not great at foreseeing timing of rate increases and so failed at hedging their risk, so I question insiders' rate forecasting ability.
Former 'best of breed" mREIT king Thorburg Mortgage also saw lots of insider buying during its decline - and eventual bankruptcy - in 2007-9. The cause of death was a sudden unforeseen decline in the book value of its MBS (mortgage-backed securities) portfolio that resulted in margin calls (remember, mREITs borrow to finance their lending) that ultimately exceeded their available cash. The lesson: don't have too much faith in insider buying, especially with mREITs.
2. 10-year bond yield: NLY bulls say that rising 10-year bond yields imply rising income for NLY. Correct me if I'm mistaken (mREITs are not my specialty), but isn't NLY's business model is basically to buy higher yielding long-term mortgages and finance those purchases with very short-term borrowings (which are at lower rates) that are constantly refreshed with new short-term borrowing?
Thus profits are all about having the widest possible spread between LONG-TERM rates at which NLY lends out for revenue, and SHORT-TERM yields which are NLY's big (and LEVERAGED) expense. How will that spread be maintained or grown?
In other words, you can't just point to rising long-term yields; they're only half of the net income equation - the revenue side. You also need to look at the expense side, short-term yields. For NLY or other mREITs' income to increase, they need to rise more slowly than long-term rates, right?
3. Cheap valuation: The NLY bulls that it sells at a discount to book value. Does that book value already discount the decline in value of their mortgage portfolio (remember, like a bond, the market value of a mortgage drops for investors when the gap between its yield and that of lower risk debt - like the 10-year t-note - narrows)?
What makes them believe that rates will not increase materially in the coming year? Sure, the Fed doesn't want them to rise, but it's not clear that the Fed is in control, given how bond markets have reacted in driving the 10-year t-note rate higher.
In theory shouldn't rising rates lower the book value of NLY's assets - long-term mortgages? What's the risk of their needing to sell assets (and thus reduce income) to meet margin calls? How high would rates need to go for that to happen?
In sum, I thought that NLY's fate depends on:
1. Long-term rates rising faster than short-term rates, which would increase its income
2. It's ability to absorb declining value of its portfolio of mortgages as rates rise.
Actually, how one answers the above two questions, seems to depend on how one answers the following questions:
What will be the timing and pace of the fed's curtailing (or tapering off) of QE? Assuming the U.S. doesn't cut back on its bond sales (it won't), that means more supply relative to demand, falling bond prices, and so rising yields.
How will the Fed taper? It buys both treasury bonds and mortgage-backed securities. Given concerns over rising mortgage rates killing housing demand, and the negative ramifications that would have for the banks and consumer spending, we suspect the Fed may cut back treasury bond buying more than MBS buying. Greater treasury bond supply means higher rates, right?
When does the Fed move from reducing QE to actually raising the benchmark Fed funds rate?
Finally, here's the most important question of all: when does the market think the Fed will do so and what will be the pace and extent of rate increases from that speculation?
Chicago Fed Chairman Charles Evens recently suggested that the first actual rate hike could come in late 2015 as unemployment is anticipated to drop under 6.5%, the Fed's presumed trigger statistic (hat tip to Seeking Alpha Market Currents and blogger Regarded Solutions for pointing it out in a recent article). That may seem to be two years off, but markets are forward looking and will start driving up interest rates at any hint that the Fed is even considering an actual rate hike.
Using the Atlanta Fed's Jobs Calculator, if labor participation rates stay steady, unemployment could hit 6.5% as early as December 2014 if the US adds 185k jobs per month on average.
I look forward to hearing your responses, dear readers.
A Final Note of Caution
Whatever conclusion you reach, don't invest too much of your ego, or capital, than you can afford to risk. As a long time asset manager at RBC-Dominion once told me regarding mREITs, the managers themselves have mostly failed to forecast rates and position themselves accordingly (ditto most of the professionals), so why should you think you'll do better?
Disclosure: I am long NLY and a variety of income stocks and MLPs. 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.
DISCLAIMER: Article is for informational purposes only and expresses only my personal opinion. I’ve no relationship with any of these companies nor am I paid by anyone to offer a specific opinion.