- The 12 bps drop in the 10 year US Treasury Note Yield from Q1E until June 12, 2014 should mean no book value losses for AGNC and NLY.
- The relatively small move in yield should mean only a small negative change in net interest rate spreads for AGNC and NLY.
- AGNC should be able to sustain its dividend. NLY may have to lower its dividend slightly.
At the ECB meeting June 5, 2014 Draghi opened the door to quantitative easing. He cut the ECB's base interest rate from 0.25% to 0.15%. He introduced a negative deposit rate of -0.1%. The ECB offered more cheap loans (a new LTRO program) to banks to boost lending. He said the ECB would work on the purchase of asset-backed securities. Meanwhile the Bank of England left its interest rate unchanged at 0.5%. These measures will likely tend to keep EU bond rates low or move them even lower. That in turn should put a cap on US bond rates. After all who would want to pay more for a Spanish 10 year note than for a US Treasury 10 year note? The yields were an identical 2.64% on June 11, 2014. The same logic applies to many other EU bonds and their rates. The chart below shows the strong downward trend in the Spanish 10 year note yield.
On top of the above the recent US Q1 GDP growth was -1.0%. The World Bank lowered its developing countries growth estimate for FY2014 from +5.3% as of January 2014 to +4.8% as of June 10, 2014. It lowered world economic growth from +3.2% to +2.8%. The EU Inflation rate for May 2014 was only +0.5% year over year. This is almost deflationary; and it partially accounts for the ECB's easier monetary policy, which seems designed to stimulate the economy (cause inflation). The other two items mentioned above could only be considered economic slowing, which would also be deflationary. These things argue against interest rates going up. Instead they suggest interest rates may go down. At the very least the upward movement of interest rates should be limited in the near term.
So far in Q2 2014 the 10 year US Treasury Note Yield has decreased from 2.72% as of March 31, 2014 to 2.60% as of this writing on June 12, 2014. Normally Agency fixed rate RMBS values will go up as interest rates go down. This means that investors have 12 bps in their pockets at this point in Q2 2014. The chart below of the 15 year FNMA 4.0% coupon RMBS for the last three months shows that its value is up about 1% since March 31, 2014.
I will use the above chart as a standard example. The amount that each fixed rate Agency RMBS is up or down may vary somewhat, but the overall direction is likely to move consistently. Since both Annaly Capital Management Inc. (NYSE:NLY) and American Capital Agency Corp. (NASDAQ:AGNC) both hold large amount of fixed rate Agency RMBS, their book values should both move up or down more or less in sync with the reverse of the interest rates.
Of course there is more to the outcomes than simple interest rates. The breakout of the portfolios should help to elucidate these (see NLY's Agency fixed rate portfolio as of March 31, 2014 below).
The bulk of NLY's holdings are still in fixed rate Agency RMBS; and the amount of 30 year fixed rate Agency RMBS is 80.3% of the fixed rate Agency RMBS portfolio as of March 31, 2014. These would probably get hurt more than 15 year fixed rate Agency RMBS if interest rates went up appreciably. However, with interest rates down thus far in Q2 2014, they should gain a bit in book value.
However, NLY had about 94% notional amount of interest rate swaps coverage on its MBS and 5.2x leverage. This will keep NLY from benefiting much if at all in book value from the relatively small decrease in interest rates. Keep in mind the expense for 30 year fixed rate Agency RMBS protection with interest rate swaps is much more expensive than the expense for 15 year fixed rate Agency RMBS protection. This means NLY will likely profit less in term of book value gains than an Agency mortgage REIT such as AGNC, which has a much higher percentage of 15 year fixed rate Agency RMBS.
NLY probably has a bit of a problem. It may have to decrease its dividend. It had core earnings of $239.7 million in Q1 2014 (+$0.23 per common share). However, the dividend was $0.30 per common share. From a quick look it appears that NLY will gain little if any book value given current values; and it will likely see its net interest rate spread narrow still further as interest rates are down slightly. CPR's (constant prepayment rates) have generally been up slightly in Q2 from the end of Q1 2014. This too should hurt the net interest rate spread. This dropped from 1.43% for Q4 2013 to 0.90% for Q1 2014 as interest rates dropped, so it is low already. Right now it seems likely to drop a bit further, since interest rates are down again. This will likely make the dividend rate unsustainable. The next quarterly dividend might drop to $0.25 per common share. The company won't want to go too far into the hole to pay the dividend.
The book value should stay about even. This is tolerable. Plus the Commercial Real Estate side of the business should have done well. This may by itself have added book value. This should still give NLY a good total economic return for the quarter. NLY is still a stock you want to own. The ultimate dividend for the quarter might be approximately 9% annualized.
In contrast AGNC whose Agency fixed rate portfolio is below has approximately 50% of its fixed rate Agency RMBS in 15 year RMBS.
This should make its repos cheaper. It should make its hedging swaps cheaper. Plus it had a net interest rate spread of 1.43% for Q1 2014 with leverage of 7.2x. If interest rates end Q2 2014 down slightly from the end of Q1 2014, the extra leverage AGNC uses should not hurt it at all; and it should instead provide greater returns for shareholders. Plus costs should be less. Therefore the net interest spread should be considerably above that of NLY's. Plus AGNC ended Q1 2014 with leverage of 7.6x. This may be enough to help it maintain its core earnings; and this may help it maintain its dividend.
Hedges had a notional amount of 94% of its portfolio as of March 31, 2014. This extra hedging seems likely to cost AGNC. However, it should not add huge losses, since fixed rate Agency RMBS value will be going up as swap values go down. Since AGNC had $1.18 in comprehensive income per common share in Q1 2014, it seems likely to be able to manage a nearly similar result in Q2 2014. It had $0.64 per common share in net spread and dollar roll income per common share in Q1 2014, including estimated "catch-up" premium amortization costs of -$0.07 per common share due to a change in the projected constant prepayment rate (CPR) estimates. If one postulates a nearly similar result in Q2 2014, AGNC seems likely to leave its $0.65 per common share dividend unchanged. This is a 10.98% annual dividend. It makes AGNC a buy.
All told AGNC seems likely to have performed better in Q2 2014. I like the fact that it has a lot of 15 year fixed rate Agency RMBS versus very little for NLY. NLY's much higher percentage of 30 yr fixed rate Agency RMBS represent a much greater extension risk for NLY. It represents higher cost for hedges and for repos for NLY. I believe AGNC's fixed rate Agency portfolio is much more appropriately designed than NLY's. Much higher interest rates will likely bear this out. AGNC is probably the better buy at this time. The book values of both AGNC and NLY should change little in Q2 2014 (as things stand at the moment).
The two year chart of AGNC provides some technical direction for this trade.
The slow stochastic sub chart is near overbought levels. The main chart shows that AGNC is in an uptrend. The book value at the end of Q1 2014 was $24.49 per common share. The stock, which closed at $23.68 on June 12, 2014, is at a substantial discount to the book value. With little book value change for Q2 2014 and a still great dividend of about 11%, AGNC's stock price should be able to continue going up.
The two year chart of NLY provides some technical direction for this trade.
The slow stochastic sub chart shows that NLY is neither overbought nor oversold at the current time. The main chart shows that NLY's stock price is in a slow uptrend. NLY had a book value of $12.30 per common share at the end of Q1 2014. If this is little changed in Q2 2014, the stock, which closed at $11.54 per share on June 12, 2014, is trading at a good discount to the book value. With a still good to great dividend, the stock should be able to keep going up. At the least it should be able to go sideways.
Investors could consider buying either of these stocks. However, AGNC seems the safer and the higher yielding one at the current time. I would wait to see what the actual numbers are for NLY for Q2 before I bought it. It is hard at this time to decide how much of a beneficial effect the commercial real estate side of NLY will have on results. With so little past history, I prefer to wait to see these results. CAPS seems to agree with this assessment. It rates AGNC four stars (a buy) and NLY three stars (a hold).
NOTE: Some of the above fundamental financial information is from Yahoo Finance.
Good Luck Trading.
Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in AGNC over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.