This is the first of a series covering in detail the highest dividends-paying equities in my trading set. The view here is that of a dividends-seeking investor in the current uncertain interest rates environment. In effect, I hope that these articles would allow you to assert whether such company is investment grade. After all, dividends payout does not matter if you cannot trust the company to hold well in the market. I also attempt to show what factors may affect the valuation of such a company, and hence shed some light on future prospects. Mind you, yes there is only one valuation and that is what is displayed on the ticker, but having a grasp of the reasons allows one to avoid hasty buy/sell decisions. Finally, in my trading style, I do try to time my purchases, and as such I hope to provide some insight on how I go about it.
Without getting into the argument relating to dividends vs. appreciation, as clearly I am a believer in dividends, as far as I am concerned, dividends payout serves as the clearest criteria for judging whether a company continues to be investment grade or not.
You see, aside from all the rewards dividends offers to the holder, which is at the center of the classical debate of "growth vs. income," I view dividends as more importantly
- Enforcing a strict and measurable metric on management performance
- Providing early warning signs of impending trouble
After all, dividends is not easily subjected to accounting tricks or classified as a "special item" -- that most cannot fathom -- on quarterly earnings. Dividends is hard currency that enters your account on payout date! Further, any of the tricks, such as using or diluting capital, to pay out dividends are easily spotted by most investors who bother to read earnings releases -- let alone digging into earnings reports.
In essence, if I were a long term investor in a company and I see dividends warning signs -- such as cancelled, reduced or delayed payout -- I would immediately dump the stock as, invariably, what comes afterwards would be worse. Think of it this way: which CEO would dare tamper with dividends payments unless the finances of the company are under severe stress?
This stress is no more obvious than what you find in mREITs. A REIT is mandated by law to distribute -- at least -- 90% of its taxable income. Yet, across the board, such companies have, and still are, reducing their payout amounts.
As Annaly (NLY) is in my trading set, I will go over my analysis of the company and why I still think it is investment grade. It is worth noting that multiple articles on Seeking Alpha discussed mREITS in general, and Annaly in particular, including my earlier article stating that mREITs are not for the fainthearted. Hence I encourage you to explore other points of view.
As far as I am concerned, viewing NLY as a sophisticated fixed income hedge fund may be the best way to approach investment in NLY or any other company in that sector.
As an overview of the company, Annaly is, at the time of writing, a $9.66 billion company in market capitalization, paying 11.76% annual dividend. It has around 946 million shares outstanding. The company has been in business since 1997.
To start my analysis, it is the people who run a company that should be an investor's first point of focus. Despite losing one of its founders, my earlier article did look into management, and my conclusion was that there was no significant change to warrant exodus or reconsideration of the effectiveness of the current management team. I will not repeat that discussion here. Having said that, an evolving concern, if we are to use the hedge fund analogy, is that management continued to garner handsome pay despite the lack of performance. Regardless of any counter argument, I believe a better tie between performance and compensation is needed.
My next focus point is finances.
On this front, if you are a long term investor in NLY, then your biggest concern should be the Book Value of the company, and not the spread of the short term vs. long term interest rates, as casual consideration of the mREIT business may lead you to believe. It is my view that the fluctuation in the valuation of the company dwarfs any perceived positives or negatives due to income/expense changes attributed to the long-short interest rates spread.
For this discussion, I shall refer to the company's latest quarterly supplemental presentation. As an aside, if you are an Annaly investor, then you should periodically read this supplemental material. Of course, the 10-Q filings should be consulted for details.
To this end, you need to consider that the assets and liabilities of this particular company are mainly interest bearing instruments and derivatives of three durations. The first category of such instruments is the long-term bond-like mortgage instruments -- the agency MBSs. As an aside, note that the company's portfolio now encompasses both commercial and residential mortgages. Slide 5 of the above mentioned presentation suggests that the company had $83 billion in agency securities and debentures, representing roughly 90% of assets. Further breakdown shown on slides 15 and 16 reveals that most of these assets are fixed income, long maturity -- 30+ years -- securities. Hence, the long term interest rates (30 years) would figure profoundly in the valuation of the bulk of these securities for standard, auditable, mark-to-market accounting.
In contrast, returning to slide 5 of the presentation, you will see that $69 billion of the financing (almost all of it) is due to repurchase agreements (repos). These are listed on slide 14 as being very short term (up to 120 days) agreements, and hence bear very low interest rates, thanks to the Fed's continuing commitment to near zero rates. Hence, other than the higher rates on the 120-day REPOs, such rates are not very far from the Fed overnight rate.
As we have discussed the assets and liabilities on both sides of the interest rate spectrum, that leaves us with the third category, which are the hedges that NLY put in place. You will find out, again on slide 14, that NLY has around $52 billion in interest rate swaps have an average term of about 5 years, and around $7 billion of swaptions with terms close to 10 years.
As such, when doing a ballpark valuation of the company, based on observed interest rates, one can roughly use the 30-year rates to judge the value of the assets, the 5-year rate to value the hedges, with swaptions affected by the 10- year treasuries. One, under the continuing Fed commitment to low rates, can ignore fluctuations in the liabilities' interest rates.
The above presentation, page 17, attempts to capture some of the sensitivity discussion. The most noteworthy point there is the fact that it seems they were able to significantly reduce interest rate and MBS spread sensitivities -- significantly -- from only three months prior.
As a follow up, I encourage all investors to compare these numbers to the impending Q4 results and presentation -- due in a couple of weeks. This will give you as an investor a feel for the composition and sensitivity of the portfolio to the interest rates environment.
The following focus should be on future prospects of the company.
In the current environment of rising long term rates, the efficacy of the hedges in subsidizing the drop in the assets accounts for a significant portion of the Profit & Loss for Annaly. Considering Fed commitment to low short-term rates, it is clear that the liabilities of Annaly are going to be under control for quite a while. That leaves the uncontrolled and significant risk of rising 5-, 10- and 30-year rates as single biggest risk to valuation.
As such, even if payout ratio for NLY stays stable or even rise, stock price will still drop if longer term rates continue to rise. I have gone on record on multiple occasions and stated that I believe that the Fed's real challenge is deflation and not inflation. Hence, in the longer run (> 2 years) interest rates will stabilize and head lower. Yet, if you are considering the next 1-2 years, and with the currently anticipated Fed action, rising long-term interest rates seem inevitable.
Relating to this point, the worst may be over. In a sense, the 10-year rates doubled since bottoming at the mid of 2012; less so for the 30-year rates. As such, if you think that the 10-year should average around 2% above the Fed's stated inflation goal of 2%, then we are talking about 30% possible rise in the 10-year rates over the next year or two; and less so for the 30-year. Hence, the impact on book value, especially that the macro economic picture is now clearer, should be more manageable than only a year ago. It is worth noting that the 5-year rates have almost tripled from their lows.
One expected, and one unexpected event can affect this analysis. The expected reduction of Fed's involvement in the treasury and MBS markets is a double edged sword. You see, despite NLY's assertion -- which I repeated in the past -- that the Fed's purchases of MBS's have depressed their margins, in reality, the positive effect of Fed's action on long-term interest rates in general and MBS spreads in particular should have more than compensated for any negative impact. This is about to end. Hence, if interest rates remain tame, as discussed above, then the reduced buying of MBS's by the Fed should play well into the fortunes of NLY. Yet, there is a chance of a spike in rates that can have a negative impact on the mREIT business as a whole.
The unexpected part of this argument, which actually may play well into NLY's fortunes if does transpire, is whether a recession develops in the near future. This does not seem likely at this point, even though the current expansion which started in Q1 2009 has reached the age of 5 -- a relatively older age compared to recent expansions. Of course, if such an even does transpire and proves to be a deeper recession than expected, then market correlations (beta) can affect all equities, including mRETs, negatively.
It is worth noting that Annaly's evolving emphasis on Commercial real estate may produce better cashflow, but it cannot and will not blunt the impact of a rising interest rates environment. Hence, I believe it behooves investors to incorporate their views of interest rates into their evaluation of the prospects of mREITS in general and NLY in particular, taking into consideration the particular asset-liability-hedge mix for each.
To finish the prospects discussion, it is important to note that some banks are getting a bit weary of the high leverage of mREITs. Actually, there were news reports of reduced funding activities by some banks. As far as NLY in particular is concerned, they have done a good job at reducing their leverage, hence -- given their book value -- it is my view that they will be less impacted by such caution than other smaller mREITs.
The final focus point to discuss is that of seeking an entry or an exit point. Here, as usual, I resort to technical analysis.
Here I use the 10-year monthly chart as a proxy for the overall trend of the company. The chart is quite horrendous to say the least. It really indicates that the persistent downward pattern is not being challenged, and the momentum downwards is far to strong to safely swim against.
The large separation between the slow moving average and the price on one hand indicates the possibility of an overreaction or an oversold situation. If you combine that with the 10 year monthly chart for the 30-year bond rates -- below -- one may see a silver lining. After all, the rates chart gives the sense of a topping off. Yet, I believe that this topping off in rates is temporary and, unless the Fed changes their stance or assessment, higher rates in the coming months are inevitable
The shorter term 3-year weekly chart of NLY does not provide any further relief. But it shows the $11/share as something to watch for.
My conclusion from all the above is that if I were a long term investor, then it is about time to place NLY on the watch list, observe the macro environment looking for signs of stabilizing long term interest rates -- in particular 30-year rates. I should be prepared to make small purchases on the way up, and tolerate potential losses, while keeping in mind that I need to treat NLY as a "hold to maturity" bond. I would still be wary of committing to large investments at this current moment, as I am of the opinion that rates still have another leg up before stabilizing or even backing down.