The Federal Reserve's "no taper" announcement led to a drop in the ten year treasury and gave a quick bounce to the mortgage real estate investment trusts (mREITs). However, that bounce was completely short lived, and then, the nail in the coffin to seal another 5% decline in most names came in the form of dividend cuts. That's right, there have been some huge cuts. Javelin Mortgage Investment (JMI) led the pack with a huge 35% cut to its monthly dividend on Thursday. Today (9/20) we learned that both my two favorite mREITs, which are the behemoths in the space, Annaly Capital Management (NLY) and American Capital (AGNC) again cut their dividends by 12.5% and 24.0% respectively! Truthfully, I thought small cuts were possible and that most of the pain was over. This was especially true given the most recent Q2 report from NLY and the most recent AGNC Q2 report. Things seemed to be improving. In fact, I think they are. Many have argued that these stocks are dead. I contend they will be fine, so long as interest rates do not rise rapidly. They can handle rising rates. It's the pace we need to be concerned with. So what to do in light of these cuts?
Here is what YOU need to do. You MUST keep things in perspective and look at where the companies are in the grand scheme of things. First, we still need to look at their performance in the last quarter to understand if things are improving. Second, we have to put the cuts in perspective, and examine the dividend histories to decide if sticking with these names is wise. Finally, a comparison of the two can help us decide which is best right now.
So which stock is better going forward? Those who follow my work know that I have built a small position on the way down in both AGNC and NLY as they have absolutely plummeted in 2013. Much of the selloff was in response to three key concerns. First was the fact that the Federal Reserve may slow or cease its mortgage asset purchases sometime this year; so far that has not panned out, but the fear definitely led to selling. Second was the fear that rising interest rates will crush portfolio holdings of the mREITs; this is true to some degree, but management can handle rising rates, so long as they don't rise rapidly like they did in Q1/Q2 2013. As a result of the rising rates, the last few quarters were quite worrisome. In this article, I will help put the new dividend cut in perspective by discussing and comparing the most recent quarter of each company, provide a dividend analysis for each company over the last few years, and lay out why I believe the bulk of the bleeding is over. Further, because I have been inundated with messages and emails about the cuts and which is better at present, I will suggest which of the two stocks I think represents a better value between AGNC and NLY.
Headline NLY Earnings From The Most Recent Quarter; They Matter
As we consider if the worst is behind NLY, I will say that overall the most recent quarter looked pretty good. NLY reported a GAAP net income for the quarter of $1.6 billion or $1.71 per average common share as compared to GAAP net income of $870.3 million or $0.90 per average common share for the first quarter 2013. These numbers are even better compared to the comparable 2012 quarter, which was reported to be a net loss of $91 million or $0.10 a share.
What About AGNC Headline Earnings
In stark contrast to NLY's headline earnings, overall, the quarter looked pretty ugly at first. AGNC reported a nasty $2.37 comprehensive loss per common share, comprised of $4.61 in net income per common share and a $6.98 other comprehensive loss per common share. This equates to an overall loss of $936 million for the quarter.
Overall Who Did Better?
To the untrained eye, it clearly seems NLY did better than AGNC. But we need to dig deeper to understand why the dividends were cut, and where the stocks may be heading.
The Key Metric: Spread on Interest Rates
How Did NLY Do?
I have to emphasize once again that the spread on interest rates is 100% key to generating profits. With interest rates moving wildly during the quarter ended June, I had expected the interest rate spread for mREITs to actually improve as I predicted that the cost of borrowing would rise at a slower pace than the rise in yield being returned from investments. For the case of NLY, this proved to be true. The interest rate spread saw a slight increase quarter over quarter. To my pleasant surprise, NLY reported a net interest rate spread of 0.98%, which was a slight but meaningful change from the first quarter, which was reported to be 0.91%. This was a great sign for those who believe that the company may be stabilizing, but unfortunately, is still well below the 1.54% interest rate spread from the comparable quarter last year. Let's look at this a bit more to see where the asset yields and costs of funds stand. First, NLY's asset yield on its interest earning portfolio for the quarter was 2.51%, compared to 2.37% for the first quarter. Not surprisingly, this is much lower than the yield in the comparable quarter of 2012. Although it is still diminished from 2012 levels, it was a marked improvement from Q1 2013 of 6%. Furthermore, NLY's average cost of funds (derived from the cost of repurchase agreements, other debt and interest rate swaps) increased 7 basis points to 1.53% for the second quarter, up from 1.46% for the first quarter, primarily due to higher average costs associated with entering into longer dated swaps during the quarter.
Was AGNC a Loser on The Spread?
When we turn our focus to AGNC, the interest rate spread was essentially stagnant. To my surprise, AGNC reported a net interest rate spread of 1.86%. Basically, it didn't change from the first quarter at all, which was reported 1.87%. If we exclude TBA dollar roll income, then AGNC's net spread was 1.49% -- essentially the same as Q1, which was reported as 1.51%. Furthermore, AGNC's asset yield on its agency security portfolio for the quarter was 2.92%, compared to 2.80% for the first quarter. The annualized weighted average yield on the agency security portfolio was 2.63% for the current quarter, compared to 2.64% for the prior quarter, backing out the amortization catch-up payments. Overall, AGNC's average asset yield reported as of June 30, 2013, was 2.71%, a four-basis-point decrease from 2.75% as of March 31, 2013. Furthermore, AGNC's average cost of funds (derived from the cost of repurchase agreements, other debt and interest rate swaps) increased 15 basis points to 1.43% for the second quarter, from 1.28% for the first quarter, due to higher average swap costs associated with entering into longer dated swaps during the quarter. As a result, the average cost of funds as of June 30, 2013, increased 15 basis points to 1.47% from 1.32% as of March 31, 2013.
The Spread Helps Put The Cut In Perspective
To put this all into perspective, the cost to borrow rose but the average yield on assets rose at higher absolute amount, leading to a higher interest rate spread quarter over quarter for NLY. Thus, earnings potential as a result of the interest rate spread has started to rebound. For AGNC, we saw a stagnant spread, but the cost of funds and yields both rose. I surmise this trend somewhat continued into Q3 and that's why the dividend is being cut more for AGNC than NLY. Essentially, it is likely that AGNC's spread is narrowing this quarter, while NLY's is remaining flat if not narrowing as well. During the second quarter it wasn't that bad for either company, but I am fairly confident this is not the case into Q3. Quite possibly, the first half of Q3 is where the damage was, as the ten year bond has stabilized in the last few weeks around 2.8%. During Q2, AGNC was a winner hands down for a larger spread, but NLY showed improvement quarter over quarter. I contend that the street likes improvement/growth, versus stability, at least for capital appreciation chances, however, we need to be concerned with Q3's numbers for both companies in light of the cut.
NLY's Dividend Cut?
The dividend has been cut 12.5% to $0.35. The dividend paid in Q2 of $0.40 per share was down 11% from the last dividend of $0.45 per share declared in Q1. I have to point out that while another cut is disappointing, it should be noted that this number was actually better than expected, as it was widely believed that the dividend was going to be cut severely in Q2 down to the same $0.35 or even as low as $0.25. The dividend paid in Q2 was well within NLY's estimated taxable income per share of $0.47. I surmise the $0.35 dividend will also be well within the earnings generated for Q3. At a current share price of $11.90, even with a cut to $0.35 this represents a still sizable yield that NLY has been known for, currently an annualized yield of 11.8%. Table 1 shows where the current dividend lies in the historical dividends paid over the last 8 years.
Table 1. Annaly Capital Management's Common Stock Dividend History, Dividends Paid Since 2006.
As we can see from the table, the stock has paid hefty dividends for the last 7 and a half years (I chose the start date from where NLY's dividend bottomed out in 2005). The dividend has not been this low since January 2008, when the dividend paid was $0.34. Since the ex-dividend date in December 2007, the stock has dropped $6.00 per share. However, the dividends paid (not counting the $0.35 to be paid in October) total $12.95. For those who bought at the time when the stock was at $18.00, you are up $6.95 per share. While this current cut is disappointing, in the continuum of dividends for this stock, if you are holding this in a retirement or other tax favored account for income, or even reinvesting the dividends, you have little to worry about longer-term.
AGNC's Dividend Cut?
The cut from AGNC has be a bit more concerned than the cut from NLY, but that is more because there is less history with AGNC versus NLY. The current dividend to be paid will be $0.80 per share. This cut is massive. The Q2 dividend of $1.05 per share was down 16% from the Q1 dividend of $1.25 per share. The current dividend is now in line with where some colleagues were opining it could drop to in Q2. In Q2 they could afford the dividend, although it was tight. At first glance in the Q2 numbers it would appear that the dividend was greater than AGNC's estimated taxable income per share of $1.04. However the $1.05 payment per share is in reality less than AGNC's net spread and dollar roll income. That figure came in at approximately $1.15 per share. While the dividend paid was definitely up against this number, AGNC did have sufficient cash to pay it. I am concerned with the current cut. I know some of the cash is being used to buy back shares. That is a big positive. But the cut to me signals trouble ahead for the Q3 earnings. At a current share price of $23.05, this represents a much smaller yield that AGNC has been known for, which is currently 13.8% on a forward basis. This is closer to NLY's historical yield. But where does the dividend measure up historically with AGNC's past payouts (table 2)?
Table 2. American Capital Agency's Common Stock Dividend History, Dividends Paid Since 2008.
Ex Dividend Date
Dividend Paid Date
Clearly, the stock has paid hefty dividends for the last five years (note I provided history since inception of the company's dividend). The dividend at $0.80 has not been this low since the summer of 2008, when the dividend paid was $0.31. The closest dividend this low was since the in April 2009 when the dividend was $0.85. Since 2008 around the time the first dividend was paid, the stock is actually up about $6.00 per share. Furthermore, the dividends paid (not counting the $0.80 to be paid in October) total $26.16. For those who bought at the time when the stock was at $17.00 in summer 2008, you are up $32.16 per share (not counting any dividend reinvestment). In the long run, while this current cut is disappointing, it's just more money on top of what has been made by those who invested early. Like, NLY if you are holding this in a retirement or other tax favored account for income, or even reinvesting the dividends, you have little to worry about longer-term. I will note however, that the cut was a lot higher than I expected, so I am concerned with upcoming Q3 earnings.
We Cannot Forget The Importance Of Book Value
NLY's Book Value At End Of Q2
Book value dropped but as of June 30th the stock was indeed trading below tangible book value. On June 30th, the stock was trading around $12.50. The book value was reported to be $13.03, which was a $2.16 drop from the end of Q1. However, it also meant that the stock was trading about 5% below book value, indicating at the time it was probably a decent buy at the time.
AGNC's Book Value At End of Q2
As of June 30 the stock was indeed trading well below tangible book value. On June 30, the stock was trading around $23.00. The book value was reported to be $25.51, which was a $3.28 drop from the end of Q1. However, it also meant that the stock was trading about 12% below book value, indicating at the time it was a great buy.
AGNC Is Buying Back Shares Sub-Book Value
AGNC upon release of their dividend cut announcement also announced that during Q3, it made open market purchases of approximately 11.9 million shares AGNC common stock, or 3% of the outstanding shares as of June 30, 2013. The shares were purchased at an average price of $22.16 per share, including expenses, totaling approximately $263 million. Since commencing a buyback program in Q4 2012, AGNC has purchased approximately 14.8 million shares of American Capital Agency common stock for total consideration of approximately $347 million, including expenses.
Take Home Messages
Both companies improved in Q2 versus Q1 2013. The earnings were pretty good for NLY and not so great for AGNC. The interest rate spread rose nearly 10% quarter over quarter for NLY, but was stagnant for AGNC. With both companies announcing a dividend cut, I surmise that both companies spreads may be narrowing. Another important metric is book value. This measure should properly determine the share price of your mREIT and be used as a basis for deciding whether to buy or sell. Book value for both companies was above the stock price at the end of Q2 and given that interest rates have been somewhat stable in Q3, I believe book value has declined only slightly, probably less than 5% for both companies at most in Q3.Then there is the dividend cuts. AGNC's cut was massive but still pays a higher yield. I am concerned with how fast the dividend is deteriorating compared to NLY's. For those who are holding these stocks for the dividends, particularly in tax favored accounts, you should be ok longer-term. There may be more pain ahead, but the dividends paid by these companies cycle up and down. Table 1 shows the fluctuation in NLY over the last 8 years for example. In most situations, investors who have been with either company for four or more years are likely ahead. Those who have purchased in the last two years are probably in the red, but you could use the selloffs to lower cost base, or simply hold and collect dividends. I promised to choose which company I like better right here. While I like both companies, and hold a substantial position in both (my NLY position is now my largest mREIT holding followed by JMI then AGNC), right now I believe that NLY is the better buy of the two stocks based on the analysis presented above. Finally, keep the cuts in perspective. The first half of Q3 continued to see volatility in interest rates and mortgage securities. So long as interest rates remain relatively stable or rise slowly, management of both companies can deliver results. Bottom line, DON'T PANIC.