The drumbeat of the Federal Reserve beginning to cut back on its purchases of mortgage backed securities comes to a head this coming week... maybe. The share prices of both Annaly Capital (NLY) and American Capital (AGNC) will be moved in one direction or another just by the Fed's actions, or lack thereof... maybe.
The confusion of course will not end until one of two things occur: The Fed gets out of the way completely, or interest rates co-operate with the needs of both of these huge company's business models.
Let me try to break this down for us regular investors to chew on. If the Fed takes its foot off the gas pedal slowly, keeps ZIRP in place, and interest rates move up slowly and less erratically, both AGNC and NLY have an opportunity to get their hedging in place, their leverage goals defined, and the ability (and time) to move lesser quality "inventory" into more profitable "inventory". If this scenario occurs, then I believe that both NLY and AGNC share prices will move up. Perhaps they might move more than 15%, which is where they were when I penned this article.
At the time, NLY was selling for $11.69/share and AGNC sat at $22.48/share. As of the close of business on Friday, NLY was $9.94/share or 19% lower, and AGNC was $20.02/share or 12% lower.
An ugly sight for unfortunate shareholders who might have purchased both of these stocks within the last 12 months or so. Granted, those lucky shareholders who have had the stocks for extended periods of time have, at the very least, been paid for the risk of hanging on to the shares, and some have a net cost basis of close to zero. Kudos to those fortunate folks.
For the rest, it has been an unfortunately painful 60 days. The 10 year Treasury rate has also shown where it is heading:
As I have noted, there is a scenario where these stocks might recover. I happen to be of the opinion that if this does occur, it will be a temporary respite as both of these companies will more than likely announce significant dividend cuts, just in time for the holidays.
That probably will send the share prices down once again, and then shareholders will once again need to decide whether or not the rewards outweigh the risks to keep holding these stocks.
How Much Might The Dividends Be Cut
I am not a math whiz but I do know that there will be plenty of pressure on both stocks to cut the dividends due to declining taxable income. Scott Kennedy has just about the most in depth analysis in his series of analytical articles on AGNC. I urge anyone who wants to dig deeply into the math behind the equations, to read his four part series.
I read just about every word and I admit that most of it was well over my "pay grade". What I clearly understood was this:
The following are my best and worst case dividend range scenarios for the fourth quarter of 2013:
1) Best Case Scenario = Quarterly Dividend of $0.75 - $0.80 Per Share
2) Worst Case Scenario = Quarterly Dividend of $0.50 - $0.55 Per Share
I personally feel the best case scenario has a very low probability (10% chance) of occurring while the worst case scenario has a low to moderate probability (30% chance) of occurring. Through the analysis performed and discussed above, I believe the following middle-of-the-road scenario has the highest probability (60% chance) of occurring:
AGNC's Dividend Range Projection for the Fourth Quarter of 2013: $0.60 - $0.70 per share
AGNC's Exact Dividend Projection for the Fourth Quarter of 2013: $0.60 per share
Scott also feels that since there is a considerable discount to book value, the company can continue buying shares at a discount, which will prove to be a positive. Normally of course I would agree, but nothing has helped at this point anyway. Insider buying, share buy backs, and de-leveraging have done nothing to stop the slide.
NLY on the other hand does have a slight advantage right now. It had cut leverage well before AGNC and is now in the 5.4-6.0 range, and is placing more emphasis on the acquisition of CreXus, which is a commercial REIT.
This gives the company some diversity and flexibility moving forward, but given the volatile interest rate environment, the hedging that NLY has had in place, has seemingly cost NLY even more money just to be more conservative.
As a result, the share price has fallen further, percentage wise ,than AGNC, but Annaly MIGHT be in a better position moving forward. NLY can also buy back more shares, and they have also had noteworthy insider buys, which usually does give investors a positive indicator.
Once again though, nothing has stopped the bleeding.
If I were to guess at how much the NLY dividend gets cut to, I would say it would be between $.20-$.25/share ,simply because profits have taken a big hit in the last quarter.
Let's Say The Fed Tapers But Interest Rates Do Not Co-operate
This is where the water gets muddy. My opinion is that if the Fed tapers and interest rates rise rapidly, then all bets are off and these stocks will head significantly lower. Both NLY and AGNC will not be able to turn their "inventory" quickly enough, the hedging will not work as hoped or planned, and we could see further erosion of dividends in further quarters ahead.
Now since I always get slammed for suggesting that these stocks can tank further, I wrote this article, which only had major research analyst firms opinions.
Rather than having the rotten tomatoes tossed at me, I felt that these firms get paid well enough to take a few hits, and of course there were readers who said that these firms have no clue, and do not listen to analysts anyway. Well, who do these investors actually place any credence towards?
If the handwriting is on the wall, and the stock action and dividend cuts are staring you squarely in the face, and you have chosen to use the hope and pray strategy, there is nothing anyone can say that is pointing out the negative and the obvious, that you will like to hear or read.
Believe it or not, I understand and I am also hoping that all shareholders of these two stocks come out ok, and I actually hope my opinion is wrong.
The Bottom Line
I realize that pre-payments have declined, and that if the Fed puts off tapering while interest rates stabilize, that these stocks might have some upside ahead.
That being said, it is clear to me that the low interest rate cycle is coming to a close, either this month or next, or the next after that, and those 10 year Treasuries will climb faster than either you or I expect. It is that scenario that will keep me on the sidelines until the Fed gets out of the way completely, and actual, real market forces settle in.
There are times when it takes a long time for the dust to settle, and I simply do not have that kind of time, or stomach, to endure the potential pain.