After repeated inquiries regarding the health of Annaly Capital Management (NYSE:NLY) following the recent dividend cut I felt compelled to compose this article. Basically, I think investors just need to relax and remember why you bought shares in the first place. Did you buy for a trade? If so, take the hair cut, move on. If you bought for a longer term investment, to collect and/or reinvest high dividends, then pay special attention. You are the shareholder that needs to take it all in stride. I agree with the legendary Bobby McFerrin, and I argue, "Don't Worry Be Happy."
Why? First you must realize that what is happening with the share price decline and subsequent dividend cuts have been reactive to present/past events, not predictive of the future. Don't listen to people who tell you the party is over, especially if they have no data to support their claim. The truth is I don't know for sure where NLY's price is heading, or where interest rates are going. If I did, I probably would be enjoying the good life retired in my 20's on my own private island deciding which yacht I wanted to go out on the water in today. I digress. What I do know is that it is time to trust the well compensated NLY management to readjust the portfolio going forward, take advantage of favorable situations and move forward. Do this, and the dividends will keep flowing. Pay no mind to those saying go short or be safe and buy low paying blue chips. Folks, nobody gets anywhere by taking the safe route. Nobody can predict the future, especially those who were saying back in June that most mortgage real estate investment trusts (mREITs) would be broke by September when the ten year treasury would get to yield 3.5%. Speaking of rates, have you seen the ten-year lately? It's not even near 3.0% (figure 1). Thank the "no taper" announcement.
Figure 1. Yield on The Ten-Year US Treasury, Last 30 Days.
Why Is The Ten Year Pulling Back?
While there may be other smaller factors in play causing rates to pull back, the primary cause for the drop was the Federal Reserve's "no taper" announcement. In fact, the ten-year is now at its lowest point since August. There is an old saying that the stock market is a leading indicator of things to come 6 months later. Well, I will tell you that this is not the case for individual stocks. If it was, wouldn't shares of NLY had powered higher back in March to April 2013 in anticipation that the Fed would not taper. Instead the mere fear the taper would come drove rates up extremely from April 2013 to August 2013 (fig 1). The recent extreme volatility in interest rates and mortgage backed securities that occurred from May 2013-July 2013 resulted in the mREITs plummeting, not rising. So it stands to reason that the stock of NLY will respond and equally as important, won't the company prosper if the environment is becoming so more amendable to the mREITs. Rising rates are ok, stable rates are great, declining rates are ideal. They all feed the all important interest rate spread. This is setting up now. The tail end of Q3 will help Q4 start very strong. So just why are you so worried over the recent dividend cut and the still depressed share price in NLY? It doesn't make sense. What you need to do is look ahead to what may happen. Sure interest rates have to rise; the key question is, how rapid will they rise? Right now, be happy they are going down. Right after the announcement it seemed these stocks were off to the races. But the initial bounce we saw post-announcement was completely short lived, and then the dividend cut announcements came.
On Friday 9/20 we learned that both NLY and its main competitor, American Capital (NASDAQ:AGNC) again cut their dividends by 12.5% and 24.0%, respectively. While I suspected small cuts were possible and that most of the pain was over, I was a bit surprised by NLY's cut. This was especially the most recent Q2 report. Things seemed to be improving. In fact, I think they are. The ten-year is definitely stabilizing as for now its under 3.0%, sitting at 2.61% right now. The declining interest rates and a stabilization of said rates is exactly what NLY needs. Most of the pain we experienced in late spring and this summer was from volatile rises in the rates; volatility as a result of speculation over the Fed's exit. So yeah NLY cut is dividend for Q3. But it does not AUTOMATICALLY mean that things are getting worse. I will admit, this sector is not for the weak stomach type investors. There is risk. However, everyone who is in this as an investment needs to relax and not sell when things are looking up. Primarily, realize that if you are in this for the long-term, then you have to trust the management to keep delivering results and feeding you dividends. Dividends; the main reason you signed up to own NLY.
In this article, I will provide solid context as to why I think things are improving for NLY which will help put the new dividend cut in perspective by discussing and comparing the most recent quarter, providing a dividend analysis for NLY starting for those who bought 2011, when most investors I have spoken to first got into this sector, and lay out why I believe the bulk of the bleeding is over. Despite my posts regarding the sector's outlook, I am still receiving questions asking if now is the time to sell. Simply put…NO. I felt compelled to reassure NLY investors with the support of data to help set your mind at ease.
I Believe Interest Rate Spread Will Hold, If Not Improve From Q3 Into Q4
One of the key metrics for these companies is the interest rate spread. It is absolutely critical. In the second quarter, 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.
Q3 Started Bad, Ending On A High Note
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. I surmise this trend somewhat continued into Q3 and perhaps related to the spread pressured in early Q3, the dividend was cut. Essentially, I think it was likely that NLYs spread was narrowing into Q3 because the ten year was still rising, but this may have turned around here in September as rates have pulled back substantially and have been stable. Overall, I think that the profit potentials are improving for the sector here in the last month of Q for NLY as well as mREITs as a whole. Should this continue, this could be the last dividend cut we see for a while. But what about the current cut?
Addressing The NLY Dividend Cut
I think the dividend cut is reactive to the first half of Q3 being pressure. 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 what was expected to happen in the second quarter! In Q2, it was widely believed that the dividend was going to be cut severely, likely down to this 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 $12.03, 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%. The one thing I will caution is that the cut to me signals potential trouble ahead for Q3 earnings. However, given that rates are down in September, the spread may be widening, and could lead to a very strong start into Q4. At current levels, I think there is now risk to the upside for the share price. If NLY pulls off an earnings beat, shares could really move. If not, the selling will likely be mild. But we should still collect a nice dividend in Q4, to cut into any losses. Further, those who are in this for the long-term with losses on paper may not are not down as much as they may think.
Just Relax, Collect The Dividends And Consider Reinvesting.
NLY has been paying a strong dividend since the late 1990's. Many of my readers who have asked me for advice directly often cite they bought in and held strong since 2010 or 2011 when these stocks were first widely being recommended. I often say, it is probably not as bad as you think. Any losses are on paper. You need to remember why you bought NLY. To collect the dividend! To see where some of these buys might be, with a worst case scenario analysis, I generated table 1 to see how much an NLY investor would be down who got in during December 2010.
Table 1. Annaly Capital Management's Common Stock Dividend History, Dividends Paid Since 2011.
Ex Dividend Date
Dividend Paid Date
As you can clearly see, NLY has paid bountiful dividends for the last three years. The dividend at $0.35 is obviously at the lowest it has been in the past three years, and wasn't this low since January 2008 when the dividend was $0.34 (data not shown). Ok, so what if someone got in at the highest possible price during December 2010? Let's assume they purchased shares once, not adding to declines or reinvesting any dividends. This buyer with awful timing would have acquired shares then at $18.37 a share on December 22, 2010. Thus, as of the current price of $12.03, this person would be down $6.34 or 34%. OUCH. That is a real disappointment. However the dividends paid (not counting the $0.35 to be paid in October) total $5.98. Therefore, the most unlucky buyer is still down a negligible $0.36, and will be about completely even should the share price hold current levels till the dividend is paid out in October. Should the shares hold around this price or go up, all future dividends are gains. When the shares rebound, real gains are had, solely because of the dividends. So, I recommend you calm down. Everyone who bought in prior to this and collected earlier dividends is likely up nicely. This example isn't all that fair, because most buyer (wisely) should build a position on the way down, especially a long-term holding. So, yes, the short-term pain is real. The disappointment of a lower share price from where you may have bought and being paid less to wait for a rebound is not easy to stomach. But, look at it objectively. You could dump now, on the cusp of a potential breather for this sector, and an improving climate. Or, you could hold tight, be happy to still collect 142%. Take the dividend, or reinvest it. Remember, these stocks work best in tax favored accounts such as IRAs or ESAs.
NLY's Book Value
As of June 30 the stock was indeed trading well below tangible book value. On June 30, the stock was trading around $12.50. The book value was reported to be $13.03, which was a $0.53 drop from the end of Q1. However, it also meant that the stock was trading about 4% below book value, indicating at the time it was a decent buy. When the dividend was announced, NLY didn't release a book value. Judging by the stated book values of others, it is likely the book value had declined 3%-8% since the last announcement. This is just a rough guess based on the performances of those mREIT companies that did announce a book value at the time of dividend announcements in Q3. Thus, I surmise book value was approximately $11.50-$12.12. Furthermore, with the recent stabilization and declines in the ten year treasury and subsequent benefit to the spread, it is likely book value has rebounded slightly since the announcement. At $12.03 per share, it is likely NLY is still trading around or slightly book value.
Take a deep breath and ask yourself why you are in this stock. The dividend cut and decrease in share price in 2013 is disappointing. But we have to give management time to adapt to the new environment. Interest rates are stabilizing. In fact, the ten year is down its lowest levels since August. Finally, for those who are in the red with their investments in NLY, keep collecting and/or reinvesting dividends. You must be patient, as the hypothetical investor at $18.37 in December 2010 is essentially even. Disappointing after three years, but can still collect dividends. Reinvestors will be rewarded handsomely when shares rebound. Income investors who are down can simply collect income, however if the shares need to be sold at a loss from where they were bought, it could have a serious impact on total returns. Remember, right now, those who haven't hit that sell button have not lost anything. Just relax, everything is unrealized. It may take time for the macro environment to return to a highly favorable situation like we have had from 2010-2012, possibly a decade, but things are moving nicely lower. We are about 35 basis points off the recent ten year treasury high in August. That will seriously help the spreads This will help in the short-term. For those who are down on their initial investment right now, my analysis suggests that time is on your side, even if the dividends fluctuate badly overtime. It highlights the importance of timing one's buy, as well as makes a strong case for reinvesting dividends. In my opinion, significant gains can be made overtime in tax favored accounts, so long as investors can stomach the volatility in share prices and dividends paid. NLY has been in the game a long time, and I don't see them going out of business any time soon. It's a long-term winner among mREITs., despite the recent pain. Just sit tight, pocket the dividends and keep an eye on rates and an ear to the Fed.