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As most of us are painfully aware, the mortgage real estate investment trusts (mREITs) have been among the weakest stocks of the last six month in an otherwise strong bull market. However, in this article I will provide evidence as to why I think things are starting to look better for my top holding in the sector, Annaly Capital Management (NLY). In fact, there are some signs that indeed this may be the case. At the most basic level, the last few weeks of the third quarter and the current fourth quarter have provided an environment that has been quite strong for the company, but understanding where the positives and negatives reside is key to deciding if the stock is a buy with defined upside at these levels. On the surface, things are looking much improved in recent weeks after the absolute massacre that has occurred in share price which led to several cuts to dividends paid in 2013. Figure 1 shows what has happened to the share price of NLY year to date, whereas figure 2 documents share price since the fourth quarter began.

Figure 1. Share Price Of Annaly Capital Management in 2013.

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Figure 2. Share Price Of Annaly Capital Management, Fourth Quarter, 2013.

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As shown in figure 1, shares of NLY are down approximately 15.2% year to date in 2013, primarily as a result of being pressured by a sharp rise in interest rates that occurred from April to September which led to a decline in value of mortgage backed securities and subsequent dividend slashes this year (table 1). To understand why the quarter may be doing better, we have to revisit the basic formula for how NLY makes money.

Table 1. Dividend History of Annaly Capital Management, 2013.

Ex-Dividend Date

Dividend Paid Date

Dividend Amount ($)

12/26/2012

1/29/2013

0.45

3/27/2013

4/29/2013

0.45

6/27/2013

7/29/2013

0.40

9/27/2013**

10/31/2013

0.35

*Note Dividend Not Yet Paid

How NLY Could Benefit From Short-Term Declining Interest Rates

I will be honest, there is a lot of subtle detail that goes into understanding the process by which NLY comes up with its top and bottom line. Overall, I still maintain that it is not too difficult to understand. Recall that NLY borrows money at lower rates and lends at higher rates. For the most part, NLY deals in agency mortgage backed securities which are simply debt obligations that represent claims to the cash flows from pools of mortgage loans. Those mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by various agencies, which proceed to convert them into bundled securities. More on this topic can be found here. These bundled securities are then bought and sold by banks, investors, mREITs etc. The value of these securities are directly influenced by interest rates. Generally the higher the rates, the less they are worth.

The rates also directly impact the interest rate spread, one of the most critical factors that can impact the bottom line of the company. The interest rate that NLY borrows at and the interest rate they lend at determines this spread. As I have stated many times, one of the key rates to watch is the ten-year treasury. As these rates rose sharply this summer, the stocks of mREITs were hammered. But if you have been watching this rate, as I have harped on, you may notice the favorable trend in the 10-year rates over the last month (figure 3). Currently, the rates on the 10-year are 2.59%, the lowest in a month. With the 10-year treasury settling and having declined, this quarter could be off to a great start. The decrease directly feeds into the spread as NLY is borrowing at a lower cost and then lending at a higher rate. The value of mortgage backed securities have also gone up in the last month, given the action in interest rates.

Figure 3. Interest Rates on The Ten Year Treasury, Quarter Four.

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Keep An Eye On The Repo Markets

As I was recently reminded, we need to be mindful of the REPO market during this recent stalemate in Washington DC. This is because there has been some volatility in the short-term REPO markets because of the grid lock in Washington. This has the potential to cut into profits. The political stand-off in Washington has wrecked havoc in short term funding markets in recent weeks. NLY's business model relies in part on the REPO market to finance much of the portfolio moves and subsequently lever up. As Seeking Alpha Contributor IRBAHTAN reminded me"

"Much of the impact was felt mostly in T-Bill and other money markets instruments, but other debt sectors were not left unscathed. We won't know the impact of this chaos in the funding markets until earnings are released, and it may not end up being significant, but it could also impact earnings if proper hedges were not in place. REPO rates certainly have been higher in the past, but recently spiked off very low levels."

Therefore, there is some risk to the funding side of the equation thus far in Q4, and this is something that I have overlooked in the past. However, with NLY's management team among the best in the business, it is likely their hedging strategies have reduced this impact. It may cut into some of the progress the company has had as a result of rising mortgage backed security values stemming from decreases in short-term rates.

What To Look For In The Upcoming Q3 Report

NLY will report earnings on November 4th, 2013, for its third quarter. I will be looking for a few key items and I believe all investors should do the same at these measures will give a strong indication as to whether my thesis that things are improving is correct. The most recent NLY earnings report followed the general trend of disappointing results in the mREIT space. The current quarter could go either way. It is likely to be painful as well, as evidenced by the selloff in the stock price in the beginning of the quarter and the slight dividend cut. However, with the changing environment that began in September, I have high hopes for NLY going forward.

I will be looking for the change in the following Q2 metrics during the Q3 report: First off, NLY reported a Q2 GAAP net income of $1.6 billion, or $1.71 per common share. The company needs to post further gains. It certainly cannot afford to report a losing quarter. With the spike in rates in July and August and despite any hedges that were in place in Q3, the quarter could be painful. However, I think this is baked into the stock price. The Q2 annualized yield on average interest-earning assets was 2.51% and the annualized cost of funds on average interest-bearing liabilities, including the net interest payments on interest rate swaps, was 1.53%, which resulted in an average interest rate spread of 0.98%. This was a 7 basis point increase from the 0.91% average interest rate spread in Q1. The company deleveraged down to 6.2:1 in Q2 from 6.6:1 in Q1. I will also be looking at the constant pre-payment rate which has declined in the last two quarters from 18% to 16%. Finally, book value drives share price. As we know, it has been hammered in 2013. In the last quarterly report book value was $13.03, down from $15.19 in the first quarter. With the increase in rates to start the quarter followed by the favorable shift in September, my money is on a very slight decline in book value of 3% to 5%. I will be looking at the performance of each of these metrics, but most important will be to listen to management's commentary about the changing environment.

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Conclusion

Right now, the mREIT sector, particularly for stronger companies like NLY, are signaling a buy as the fourth quarter is underway. What we need to look for next is NLY's reported earnings due out in a week and a half. More importantly, what is said in the conference call about leverage, interest rates and the REPO market will be key. Finally, having some guidance from management as to the book value of the company (at least as of three weeks ago) will provide us with insight as to whether it is on the rise once again, which would provide confirmation of my buy recommendation at these levels, given the positive action at the end of Q3 and the start of Q4.

Source: Annaly's Quarter Could Be Off To A Good Start