It is no secret that rising rates have hurt many of the major mREITs like Annaly Capital Management (NYSE:NLY), which now trades at a 21% discount to book value and has lost 13.5% in the last month alone. The gyrations in the bond market have absolutely killed NLY as the company has been poorly positioned to handle rising rates.
Typically, gradually rising rates can be good for an mREIT like Annaly. A steepening yield curve (when the long end of the curve yields increasingly more than the short end) increases the cash flow of an mREIT portfolio. The firms borrow in the repo market to purchase long term agency mortgage backed securities which typically have a duration in excess of five years. As a consequence as the curve steepens, these firms can generate more cash with each bond they purchase.
However, rapid movements in rates have hammered the stocks because rising yields have diminished the value of the bonds they already own. To maintain appropriate leverage ratios, Annaly has been forced to sell down its portfolio with total assets dropping $48 billion over the past twelve months, which obviously cuts its dividend capacity. With mark to market losses, NLY has lost $4.1 billion in equity this year.
A major reason why NLY is trading at such a steep discount to its current book value is that the market expects the company to keep losing money on its portfolio, further driving down book value in the coming quarters. As a consequence according to conventional wisdom, this discount to book value will dissipate. To mitigate the impact of higher rates, Annaly has begun to cut leverage at 5.4x from 6x the quarter prior, which will minimize losses and gives the firm dry powder to add to its portfolio when rates are higher. In a perfect world for Annaly, rates would stabilize for the next 6 months, so Annaly can stabilize its equity value and adjust its portfolio composition to better hedge against the eventual rise in rates. Then, we would start to see a gradual uptick in rates, and Annaly could add leverage, growing its dividend again.
After Wednesday's beige book (available here), I am more optimistic this scenario could play out. Over the past three weeks, expectations have grown tapering could start in December or definitely March. This belief has sent yields ever higher, sending Annaly's shares (and presumably book value) ever lower. The beige book changes the calculus. The beige book read "the economy continued to expand at a modest to moderate pace." This phrasing was the same as the October report, and if the Fed was unwilling to taper then. Would it taper now?
However as I dove deeper into the report, I realized the beige book actually downgraded the Fed's assessment of the U.S. economy. The beige book used the word (or a derivation of it) "weak" 29 times, up from 18 times in October. Similarly, "strong" (and its derivations) was used 69 times down from 99 times. The strong to weak spread dropped to 40 from 81. With a more dovish Chairman taking the reins in January, tapering would seem unlikely with the Fed downgrading its assessment of the economy.
Moreover, the Fed said residential construction remained "subdued." Improving the housing market is a critical goal of quantitative easing and the mortgage bond purchases. This language makes me more inclined to believe the Fed does not see the house recovery as self-sustaining just yet. Housing, of course, is an extremely rate-sensitive asset class, and higher mortgage rates could torpedo the recovery. It is even less likely that they taper when they have concerns over housing. With rates already creeping higher, I do not see the Fed tapering purchases and letting rates soar even higher.
This beige book was the Fed's way of telling investors that tapering in December is off the table. Unless there is a noticeable acceleration in economic activity, I would start to doubt that in Janet Yellen's first meeting as chair the Fed tapers its purchases. This would suggest there is now a substantial likelihood of tapering beginning in June of 2014. This revised baseline is excellent news for Annaly and the other mREITs as the Fed's decision to push off tapering will give NLY the time it needs to adjust its portfolio to shore up book value.
I believe the Fed has said rates should rise no further and will not taper for several months. I do not expect the 10 year to consistently trade above 3% over the next four months, which will be great for Annaly. With the upside move in rates over, I do not foresee NLY book value per share dropping below $11.50, which means that shares are a steal here. Then as the Fed begins to taper and rates resume their march higher in the second half of 2014, Annaly will be perfectly positioned to add to its portfolio and increase funds from operation. Below $10, Annaly offers a great margin of safety with a likely increase in the dividend in the back half of 2014. While tax selling could pressure shares through the end of the year, I think Annaly is a buy here thanks to the dovish beige book.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.