Coming into 2014, the conventional wisdom was that bond yields were going to increase as the Federal Reserve was tapering its bond purchases and would eventually raise rates, probably in 2015. Instead, rates have actually fallen with the 10 year treasury stubbornly staying below 2.5% recently. This unexpected move in bonds has helped shares of the mortgage REITs like American Capital (NASDAQ:AGNC) and Annaly (NYSE:NLY), which mainly own agency mortgage backed securities ("MBS"). After reporting quarterly earnings on Wednesday afternoon, Annaly rallied 2%, and now is a good time for investors to reconsider their position. On the whole, I believe Annaly faces some problems due to a flattening yield curve, but the valuation appropriately compensates investors for this risk.
In the second quarter, Annaly had core earnings of $0.30 while analysts were looking for $0.27 (all financial and operating data available here). This was sequentially better than last quarter's $0.23 and last year's $0.29. Investors in mREITs focus on core earnings, which is net income excluding gains and losses on investments and hedges. Annaly pays its dividend out of taxable income and has to return 90% of such income to maintain its tax preferred status. Core earnings give investors a good idea of what Annaly's sustainable dividend would be. Over the past nine months, Annaly has been able to maintain a $0.30 quarterly dividend. With these results, I expect Annaly to hold the dividend steady with neither a cut nor increase likely for the duration of 2014. This dividend gives NLY a fantastic yield of 10.6%.
Annaly is able to pay such a hefty dividend because it uses leverage to increase cash flow. It purchases MBS and then through borrowings, frequently on the repo market, can own bonds in multiples of its underlying equity position. In the quarter, leverage was 5.3x compared to 6.2x last year. Now, mortgages performed very well in the quarter, and Annaly bought more during the quarter to participate as leverage was previously 5.2x. The value of its portfolio was $3.6 billion higher at $82.4 billion. Still, leverage is far lower than it was just a year ago, giving Annaly the flexibility to add leverage if rates rise to increase the dividend. Mortgages underperformed broader fixed income markets in July, so it was wise of the company to keep leverage relatively low.
Annaly is buying bonds that have a duration of several years while it often borrows on the repo market. With overnight rates below 0.25%, this funding is very cheap. The net interest spread on Annaly's portfolio was 1.26% in the quarter, much better than last quarter's 0.9%. It was also up from last year's 1.01%. Maintaining a decent net interest spread is critical to generate enough funds for the dividend. Thanks to gains on its portfolio, Annaly's book value increased to $13.23 from $12.30 last quarter. Including the after-hours rally, Annaly still trades at a 13% discount to its book value. This means that it would cost more for an investor to buy a similar portfolio of MBS than to just buy Annaly.
In essence, NLY make money by collecting the spread between short term and long term bonds. It buys MBS, which typically have a duration in excess of 5 years, while borrowing on the repo market, typically inside of 30 days. As the yield curve steepens (the spread between long and short term bonds increases), NLY can earn more money. On the flip side, a flattening curve cuts NLY's interest rate spread, likely resulting in a lower dividend. Over the next 12-18 months, I expect the yield curve to flatten.
By next July, the Federal Reserve will likely begin raising overnight rates, which will push up the yields at the short end of the curve. This increases NLY's interest expense, and it will need long-term rates to rise equally to maintain its interest rate spread. However, I expect the Fed to continue reinvesting principal in the MBS and treasury markets into 2016, which puts downward pressure on long-term rates. While the Fed raises short-term rates, it will still be a buyer of long-term bonds, helping to flatten the curve. Technical factors also support the flattening thesis. With mortgage activity slower than previous years, MBS supply will be relatively low. Interest rates in much of Europe and Japan are also lower than in the US, which will lead some of those investors to buy US bonds, further capping long-term rates.
By the end of 2015, I expect the yield curve to flatten by about 50bp, which will pressure NLY's dividend capacity, though it has the ability to raise leverage to compensate for lower spreads. As a consequence, I do not foresee NLY being forced to cut the dividend unless we see the curve flatten by closer to 75bp. Still in this environment, a dividend increase is unlikely. At a discount to book value and 10.6% current yield, I believe investors are being compensated fairly for the risk and would be cautiously long shares.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within 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.