Annaly Capital (NYSE:NLY) and other mREITs are, for the most part, leveraged fixed income investments. While they typically have high dividend yields, it is a by-product of their leverage that usually runs between 7-9 times as measured by assets to tangible common equity. So if they earn say 1.5% on their assets, after paying out costs (interest+expense), then the equity will earn 12%. Sounds like a great deal. With the higher yield comes higher risk, however, as witnessed recently. NLY has reduced its dividend from 55 cents/quarter in 2012 to 35 cents just recently as capital gains on MBS have subsided and interest rates have risen. The risk for mREITs comes in many forms: interest rates, yield curve slope, spreads and volatility, just to name a few, and depends highly on the manager's hedging skills (another risk). However, the allure of mREITs is that, historically, they've always been able to earn their way out of mark-to-market losses. Yes, the portfolio gets marked down but their net interest margin improves and, as long as they can reinvest at better levels, they end up growing their portfolio and dividends over the cycle and making long-term investors happy. However, as we discuss below, we believe this time will be different and that mREIT investors will experience dividend stagnancy, at best, as the ability of mREITs to rotate their portfolios into higher margins is limited.
First, let us state, we are in no way singling out NLY but instead we use the company given its long-history as an mREIT (since 1997) - in fact, we laud the company for surviving through quite a few MBS meltdowns. Shown below is a bit of the history, where we show the dividends paid on common equity as a percent of assets from 1998 to 2012. We also show the dividend yield taking dividends paid against the average stock price each year. We can see that the dividends distributed to investors has ranged from a high of 1.9% of assets in recent years (e.g., 2010/11) to a low of .3% in 2006. We also see that the dividend yield has been countercyclical, low when times are tough and high during the boon years. In that sense, one can argue that investors look through short-term fluctuations and focus on longer-term trends. The average dividend yield was 12.28% while the average dividend vs assets was 1.26%. Given NLY's portfolio asset size was $102bn at the end Q2, and assuming history holds, then a steady state dividend would be about $1.30 per share and a fair value (over the cycle) share price would be $10.66. This is not very scientific but does provide a point a reference. Most importantly, much will depend on where we are in the cycle and, looking at the chart, one might argue that we are on the downward slope.
Chart 1: Dividends/Assets and Dividend Yield ('98-'12)
Mortgage REITs earn their income (and risk) from a variety of sources depending on their individual hedging strategy. The level of interest rates impacts both book value and income (through capital gains). The yield curve slope matters as most mREITs take some rate-slope risk (borrow short, lend long). Also, the spread between MBS and their hedging vehicles (swaps) is important as is the level of market volatility as MBS investors are short options. We looked at dividends as a percent of assets (dividend efficiency) versus these market factors and found quite good, and intuitive, correlations. We were a bit surprised given the coarseness of the data (e.g., annual averages). That said, with only 15 data points, one has to be a tad careful interpreting the results. Show below are the slope, defining the relationship and the correlation. Notice that dividends seemed to be most impacted by the slope of the curve (10-year minus 3-month) - the steeper yield curves translate into fatter dividends. This can be seen in Chart 1 when the dividend trough in 2006/07 was a direct result of the very limited spread between short-term and long-term interest rates during those two years. The spread (difference between the mortgage rate and average swap rate) was also a meaningful determinant as was volatility (measured as max-min) and rates themselves. All the signs were intuitive. Higher curve, spread and/or volatility led to higher dividends while higher rates lowered dividends.
Chart 2 shows the dividend efficiency versus the yield curve slope and we can see the positive relationship along with the cycle progression. Currently, with the recent rate sell-off, the curve (10y-3m Treasury) is about 2.5% which would portend a dividend efficiency of about 1.5%. On the current portfolio, that would imply a 35-40 cent dividend. One thing of note is that the yield curve slope has historically been quite correlated with the level of interest rates. That is, as rates came down, the curve steepened. For example, from 2006-2011 interest rates fell about 2% and the curve steepened 3%. This had a wonderful impact for mortgage investments like mREITs. Lower rates led to capital gains that could be harvested as well as higher prepayments. These higher prepayments (e.g., 27% CPR in '11) could be reinvested at better spreads leading to favorable dividends. In a virtuous cycle, the improved performance gave access to the capital markets allowing equity raises and further portfolio growth at more advantageous spreads and net interest margin. NLY more than doubled assets from '08-'12.
Chart 2: Dividend Efficiency versus the Yield Curve Slope
We performed a multiple regression on all the stated factors affecting NLY's dividend efficiency and the estimate (in-sample) vs actuals are shown below. The four factors described above can explain a large percent (~90%) of dividends. One can see that there are periods when dividends disappointed (e.g., '06/'07) and vice-versa (e.g., 2012). Partly, this is a result of how mREITs pay out dividends, usually with a lag vs performance. But there are also other factors like the need to conserve capital during market troughs. Taking where we are today with a 4.5% mortgage rate, steep curve, wide spreads, one would expect decent dividend efficiency going forward to the tune of $1.75/share. Even if rates were to rise modestly, 1% over the next year, as long as short end rates do not rise (i.e., Fed tapers but doesn't raise the Fed Funds rate), then we would expect dividends to still be robust according to history.
Chart 3: Dividend/Assets and Estimate
All said though, history rhymes but rarely repeats. In particular, what enabled mREITs to take advantage of better conditions historically, like a steeper curve or wider spreads, is that they were accompanied by high prepayments. From 2000-2003, the curve widened dramatically, while rates declined precipitously, allowing mREITs like NLY to reinvest the high prepayments (33% in 2002) at better levels. Now, however, prepayments are slowing, due to higher rates, even though the investment landscape for mREITs is improving. Recently, the yield curve has steepened 100 bp, volatility has increased, and mortgage spreads have widened, all leading to better potential income. But there is the rub. While book value takes the full brunt of the move to better investment opportunities, as witnessed recently, income and dividends will be hard pressed to take advantage of the improved pricing as prepayments slow further. In fact, if rates were to continue to grind higher we could see a further reduction in NLY's dividend to the 25 cent level as mark-to-market losses feed through to income. The choices are limited. If the portfolio is not turning over fast enough, the only way to capture the improved NIM is to raise capital for new investments. We don't expect equity issuance any time soon, given where shares trade versus book value, but we wouldn't rule it out either. NLY does have an "ATM" to issue 125mn shares at the market if desired. In any case, NLY and mREIT investors need to be cognizant of these risks and ask themselves if the current yield is enough in what looks to be a bumpy road ahead.