- Unrealized gains and losses on the bulk of NLY’s assets do not appear on the income statement.
- Net interest income does not include all the expenses of interest rate swaps.
- Non-GAAP based model is therefore required to assess dividend sustainability.
- Following 8 consecutive quarters model of non-sustainable dividends, model now indicates current dividend rate is sustainable.
In a prior article I outlined a methodology for assessing the dividend sustainability of Annaly Capital Management, Inc. (NYSE:NLY). The conclusion was that a dividend of $0.35 per common share is not sustainable given NLY's portfolio leverage and interest rate spreads as of 3Q13. I now apply the same methodology to and examine whether NLY's current dividend of $0.30 is sustainable in light of the latest available information (4Q13 data) on leverage and interest rate spreads.
The bulk of NLY's assets consist of mortgage-backed securities and debentures issued by Fannie Mae, Freddie Mac or the Federal Home Loan Banks (together, "Investment Securities"). These securities account for 97.7% as NLY's asset portfolio as of 12/31/13 (vs. 99.5% as of the prior year-end). NLY relies primarily on short-term borrowings to acquire Investment Securities with long-term maturities. The shape of yield curve, the spread between returns on assets owned and the interest paid on amounts borrowed to purchase these assets, and amount of leverage (the bulk of which is generated via the repurchase markets) are the key drivers of profitability.
NLY's Investment Securities are classified for accounting purposes as "available-for-sale". They appear on the balance sheet at fair value, but unrealized gains and losses on these securities do not appear on the income statement. Instead, such gains and losses are reported on the balance sheet as a separate component of stockholders' equity. In addition, net interest income as measured by GAAP does not include all the expenses of interest rate swaps. The portion classified as "Realized gains (losses) on interest rate swaps" appears below the net income line, buried in the statement of comprehensive income.
Management therefore uses a non-GAAP definition of net interest income. This is referred to as "economic net interest income" and is derived by deducting economic interest expense from interest income, as shown in Table 1:
The next step in the analysis of NLY's dividend sustainability is presented in Table 2 below:
Table 2 provides a simple model describing NLY's bread and butter business of using short-term borrowings to acquire Investment Securities. The model highlights the improved performance in terms of net interest rate spreads. That coupled with past dividend reductions has finally produced positive coverage (i.e., above the 1.0 threshold in 4Q13) after 8 consecutive quarters of below 1x coverage. The current dividend now seems to be aligned with what NLY's basic business model can produce under 4Q13 conditions.