Seeking Alpha
Long/short equity, value, REITs, macro
Profile| Send Message|
( followers)  


  • NLY Core Earnings of $300.4 million ($0.30 per share) covered its $0.30 per common share dividend.
  • Book value increased from $12.30 on March 31, 2014 to $13.23 on June 30, 2014 (about 7.6%).
  • The total economic return for Q2 2014 was 10% for Q2 2014 alone (40% annualized), which can only be called great.
  • Read the article to find if there are any "gotcha's" in NLY's performance and strategy.

Annaly Capital management Inc. (NYSE:NLY) is externally managed by Annaly Capital Management LLC. Annaly and its subsidiaries are focused on generating long term value. NLY is a mortgage REIT that still primarily invests in Agency fixed rate RMBS. However, it has been expanding into commercial real estate debt including commercial mortgage loans, CMBS, B-notes, mezzanine loans, preferred equity, and other commercial real estate related debt investments.

NLY did well in Q2 2014. It had Core Earnings of $300.4 million ($0.30 per common share). It finished Q2 2014 with a strong capital ratio of 15.4% and leverage of 5.3x. Its book value moved up from $12.30 per common share to $13.23 per common share (+0.93). This was a 7.6% increase just for this quarter. The total economic return (book value gain + the dividend) for Q2 2014 was 10% for Q2 2014 alone (+40% annualized), which can only be called great. NLY's net interest rate spread moved up from 0.90% to 1.26%. This allowed for the good Core Earnings. The Agency portfolio increased in value by $4.6B to $82.4B. This constitutes a 6% increase for Q2 2014 and a 12% increase year to date. The CPR (constant prepayment rate) was a bit higher at 7% compared to 6% at the end of Q1 2014. However, this was still much lower than the year earlier CPR of 17%.

As interest rates go down, normally the net interest spread decreases. Therefore the above mentioned increase of 36 bps in the net interest spread is very odd. NLY's explanation for this is that it "unwound about $26B of notional value of short dated swaps." NLY believed that given the current environment, these were providing very little hedge protection.

Given that the 10 year US Treasury Note yield has gone down consistently year to date, one would have to say that NLY's management made a good call on this. The 10 year US Treasury Note yield has gone from 3.03% on December 31, 2013 to 2.72% on March 31, 2014 to 2.53% on June 30, 2014 to 2.38% as of this writing on August 7, 2014. From the last data it is clear that rising interest rate protection has not been needed so far. Saving on short dated interest rate swaps was almost certainly a good idea.

However, it is not nearly as clear that this will always be a good idea going forward. The Fed is likely ending QE3 in October; and it has said that it will begin raising its Fed Funds rate roughly 6 months after that. If the Fed does this, interest rates seem likely to rise. If NLY reinstates a large amount of short dated interest swaps out of fear of rising interest rates, it will likely see the net interest spread fall again.

To ballpark the risk, as of June 30, 2014 NLY had only about $30.8B in notional amount of interest rate swaps and $2.6B in notional amount of interest rate swaptions. This is for a portfolio with repos of $70.37B. In other words NLY is far under covered by most standards at about 47% hedged for its repos.

To more fully analyze the risks involved, it would be good to look at NLY's Agency portfolio (see below) as of June 30, 2014.

(click to enlarge)

(click to enlarge)

As investors can see the greater than or equal to 30 years fixed rate Agency RMBS have a current face value of $56,359,608,000. That constitutes 80.7% of NLY's Agency fixed rate securities. These lose value at a much faster rate than 15 year fixed rate securities. This allocation of security types in the portfolio makes NLY's bet on leaving itself unhedged for much of its portfolio much more risky; and that should worry investors. The only good thing one can say is that NLY management has been right about whether those hedges were going to be needed in the short term.

It is unclear to me what NLY management is going to do in the near future. They are clearly playing the market "by ear." If they don't hear the right thing at the right time, NLY could see huge losses. It may only be leveraged 5.3x; but that will still amplify losses incredibly when so much of the portfolio is unhedged.

The commercial real estate side of the business performed about as expected. It was 11% of stockholders' equity as of June 30, 2014 with roughly $1.6B+ in investments. The yield for Q2 2014 was 8.93%, which was down slightly from the 9.13% of Q1 2014. This is a little worrisome. It is lower than the current dividend rate; but the lowering of the yield from Q1 to Q2 2014 is a small change. Therefore the effect on Core Earnings is negligible.

In sum, I can see why NLY's management took the actions with respect to the hedging that it did. I agree that their analysis was correct this time. However, NLY has not made it clear to me exactly what their future strategy is. I find NLY's percentage of 30 year plus Agency MBS in their portfolio worrisome. When the company is also forgoing hedges to a large degree, I am even more worried. Regardless of the relatively good earnings and the 10%+ dividend, I am scared off by the risk of NLY.

The current price of $11.46 as of the close on August 7, 2014 is far below the June 30, 2014 book value of $13.23 per common share. The stock price would have to rise 15%+ just to get to its book value. However, as we saw last year, Agency mortgage REITs with high extension risk (lots of 30 year Agency MBS) do extremely poorly in a rising interest rate environment. I think I would prefer a different Agency mortgage REIT, even though NLY has been making the right decisions of late.

I am reminded of Bret Jensen's recent article question, "Who will be left standing naked when the tide goes out?" I wouldn't want it to be me. Even with the large discount of stock price to book value, I would rate NLY a HOLD. Without that discount to book value, I would rate it a SELL. NLY management could perhaps change my mind with a better explanation of their longer term strategy; but for now I would not buy NLY, although I might hold it temporarily due to the large discount to book value.

The two year chart of NLY provides some technical direction for this trade.

(click to enlarge)

The slow stochastic sub chart shows that NLY is neither overbought nor oversold. The main chart shows that NLY has been consolidating sideways for much of 2014. I am not thrilled by the Q2 2014 report. I am sure that a lot of investors will only read the headline numbers. They will likely bid the stock up. If I currently owned NLY, I might be tempted to keep it temporarily. However, as the stock price got closer to the book value, I would likely sell the stock. I enjoy sleeping at night.

NLY's lack of hedges will mean larger book value gains in Q3 2014 if interest rates keep falling as they have been. Will they? In my mind the largest reason for the recent decline in interest rates has been the Ukraine troubles, and the ensuing economic sanctions by the US and EU of Russia and by Russia of the US and EU. The growing economic sanctions are bound to lead to slowing economic conditions for all of the countries involved. Such a scenario would likely lead to a flight to quality (lower interest rates). Active investors may want to play this trend; but traditional Agency mortgage REIT investors probably will not. They will worry about the extra risk. They are income investors; and they do not want to take a chance on losing a significant part of their investment capital.

NOTE: Some of the above fundamental fiscal data is from Yahoo Finance.

Good Luck Trading.

Source: A Great Book Value Gain In Q2 2014 By Annaly Capital May Put It In Line For Stock Gains