Thus far, 2014 has been a strange year for the bond market. With the Federal Reserve tapering its bond purchases and consensus that the economy would improve, it was widely assumed that interest rates simply had to rise from record lows. Instead, the 10-year yield has actually declined this year and has been bouncing around 2.6% compared to 3% several months ago. This move has surprised many and forced covering of shorts in the fixed income space. It is in this environment that Annaly Capital (NYSE:NLY) reported its quarterly earnings, and the results were somewhat mixed. However, with a 10% yield and shares trading at a discount to book value, Annaly is an attractive for income investors with the possibility of some capital appreciation.
In the quarter, Annaly reported core earnings of $0.23, while most analysts were looking for $0.29 (all financial and operating data available here). This miss sent shares lower by about 5%. In the December quarter, core earnings were $0.35, while last year's quarter boasted core earnings of $0.29. This core earnings figure was disappointing and will leave some investors concerned about whether or not Annaly can maintain its $0.30 quarterly dividend, which is based on taxable income. The company did declare its first-quarter payout already, so these results were enough to keep the dividend at that level. Still, if these disappointing results become a trend that may necessitate a cut to the dividend. Based on the internals of these results, I don't think that will be the case.
Over the past twelve months, Annaly has been methodically reducing its leverage. Annaly invests almost exclusively in agency-backed, mortgage-backed securities ("MBS"). As they are backed by agencies of the US government, they carry virtually no credit risk. Thanks to this, Annaly can use repurchase agreements to add significant leverage to generate strong returns for investors. Now as rates rise, the value of bonds falls, which erodes book value and elevates leverage. As a consequence during 2013, Annaly was cutting leverage to limit the book value erosion, though using less leverage does cut net interest income. Once rates begin to rise (which I continue to expect will happen sometime this year), Annaly will have a lot of dry powder, and it can purchase higher-yielding bonds and increase leverage, which will increase taxable earnings and the dividend.
Now, Annaly was hurt this quarter because a core assumption of the strategy, rising long-term interest rates, simply did not happen. Instead, the yield curve flattened, which pressured net interest margins, and lower leverage further cut core earnings. At the end of the quarter, leverage stood at 5.2x. This compares to 6.6x last year. Annaly currently holds $77.8 billion of bonds, compared to $112.2 billion a year ago. Now, Annaly's portfolio did grow by $4.4 billion sequentially, as the company expanded the portfolio a bit to negate the impact of tightening spread and market values increased, but the strategy of reducing the portfolio has had quite the impact over the past year.
During the quarter, we saw a flattening of the yield curve, which hurts Annaly as it lends at the long-end by purchasing MBS while borrowing through short-term debt. Due to timing issues, the first quarter also frequently has the lowest net interest margin of the year. In the quarter, Annaly earned a net average spread of 0.90%, compared to 1.43% in the previous quarter and 0.91% in the prior year. Basically, core earnings were lower than the previous quarter because spreads were lower, and core earnings fell from last year because the company used less leverage.
Now, falling yields do have one positive implication. They increase the market value of Annaly's portfolio, which in turn increases book value. During the quarter, book value increased by $0.17 to $12.30. Based on where shares were trading after-hours, there is a 9.5% discount to book value. Annaly's strategy of cutting leverage over the past year has stabilized the erosion of book value, which should hold above $12 for the year. It is now cheaper to buy Annaly than to rebuild its portfolio yourself. This discount provides further margin of safety for investors who are interested in buying the stock.
Overall, movements in the bond market that tightened spreads made this a more difficult quarter for Annaly with disappointing core earnings, though the increase in book value was positive. While slow growth and geopolitical problems have pushed interest rates lower, I do believe over the next few years interest rates will gradually rise to more normal levels. This can be positive for Annaly as it adds leverage as rates rise, increasing net investment income. Annaly should be able to pay $1.20 in dividends this year and a higher total of roughly $1.40 in 2015 as the yield curve steepens. Under $11.50 and at a discount to book value, Annaly is still an attractive investment for income-oriented investors.
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.