Annaly Capital Management, Inc (NLY) is an internally managed mortgage REIT company, which primarily invests in agency residential mortgaged-backed companies. I am neutral on the company, mainly because it has a high payout ratio and a dividend cut is on the cards in the near future. Also the company missed its earnings and book value targets in the third recent quarter. Furthermore, the rising interest rate scenario continues to suppress the price-to-book value for mortgage REIT companies.
An attractive dividend yield is one of the major attractions for investors, but for the last three quarters, NLY has been cutting down its dividends. But still the dividend of $0.35 per share is also not sustainable with a core EPS of $0.28 per share. So, I believe that very soon, the management will once again be forced to cut down its dividend yield to make it more manageable over the long term.
Change in percent (QoQ)
American Capital Agency (AGNC)
Hatteras Financial (HTS)
ARMOUR Residential (ARR)
CYS Investments (CYS)
Source: Company Data
The company has not yet announced its fourth quarter dividends so I have used the third quarter information in the table given above. NLY has one of the lowest dividend yields among its peer companies and it is expected to decline further, which means that investors have other high yielding options available in the world of mortgage REITs.
NLY has adopted a defensive approach just like other companies. It has managed to sell off its agency MBS portfolio, which declined by 11.8% in the third quarter to $85.5 billion. Consequently, the leverage was reduced from 6.2x to 5.4x. On the same lines, NLY also increase its hedging by adding $3.7 billion in swaps, which accumulated to a total of $52 billion by the end of the recent third quarter. Although all these initiatives do make sense in the current rising interest rate scenario to preserve its book value (which declined by only 3%), but it has adversely affected the company's earnings and has elevated the payout ratio.
An encouraging sign is that the company has managed to tighten its duration gap by selling its 30-year agency MBS. It also added almost $1.3 billion in commercial finance loans and it is expected to reach $2 billion by the end of this quarter. Net interest margin also improved by 3% QoQ and the pre-payment speed declined to 13%. Also, NLY is trading at a significant discount to its historical price-to-book value as shown in the graph below. I expect the gap to narrow down in the future, which will result in price appreciation.
Why tapering is not a big problem?
The Fed has been discussing tapering since May'13, which has triggered a rise in interest rates. I believe that the market has overcompensated because the Fed clearly states that it will make sure that the economy is strong enough to support itself before making any cut down in asset purchases. And we know that REITs have performed well in the past in rising interest rate scenarios in a strong and growing economy. In the recent third quarter, the U.S. economy expanded by 3.2% QoQ, which is an encouraging sign, confirming my thesis that the market has overreacted to the possibility of tapering.
The Fed has been closely following the economic data as it wants to be sure before it decides to start cutting down on asset purchase. They have been looking at some mixed results. Job data has been encouraging for the last two months as it beat analyst expectations, and most importantly, in the last month, the overall unemployment rate has dropped to 7% from 7.3% in October. Corporate profits have also increased by 7.5% in the third quarter. However, inflation continues to be stagnant and well below the Fed's target. So, the Fed is meeting next week on December 17 to make a decision of when to start tapering. Also, important questions like will the encouraging job data and solid GDP growth be enough,or will the Fed wait for right inflation numbers will be answered.
We all know that sooner or later, tapering is coming, but the important thing to understand for investors is that if the economy is on the rise and the numbers are solid, then a gradual cut down of $85 billion is not such a worrying sign. I believe that Fed will slowly cut down on its assets, while short-term interest rates are expected to remain the same at least till the first half of 2015.
The company's dividends are under pressure because of an elevated payout ratio. It needs to strike a balance between its defensive strategy and earnings to maintain its attractiveness for income seekers. NLY has also been diversifying is portfolio, which is an encouraging sign for the prospects of its future growth. Lastly, I believe tapering will not remain such a big concern if economic indicators continue to show solid trends.